Testing for Basis Risk
Every balance sheet has a complex set of driver rates. These are the Treasury curve points and other market rates that determine your pricing today and your repricing as interest rates change. Traditional rate shock and rate ramp IRR tests don't address the exposure of your earnings to varying speeds of adjustment by different driver rates, referred to as basis risk, because these tests move all driver rates by the same amount. But how to avoid this serious shortcoming in a world where basis risk is a key performance challenge?
To quantify basis risk, you need the right interest rate tests
There are two key dimensions to basis risk: (a) that arising from broad changes in financial market conditions over time and (b) that arising from changes in yield curve shape.
To address potential earnings exposure to broad changes in financial market conditions over time, non-linear rate ramp projections are the answer. In these tests, each driver rate moves at its appropriate speed relative to other rates once a scenario is defined (for example by a Fed move or other shock). Your balance sheet reprices based on changes in each driver rate, thus properly defining basis risk.
To address potential earnings exposures to changes in yield curve shape, non-linear rate ramp type projections are again the answer. In this case, however, selected short and long term Treasury rates are moved to define a flatter or steeper yield curve, with all other driver rates evolving inline. Your balance sheet reprices based on the specific changes in each driver rate along and associated with the yield curve, thus properly defining basis risk.
In either case above, the basis risk tests you choose need to be produced by scenario specific forecasts based on advanced statistical analyses of historic interest rates. Only if this is so will driver rate projections have a sound basis in financial market experience. A further advantage of statistical based tests is that the projections evolve with market conditions over time, based on continuous re-estimation of financial markets history. The projections thus have continuity from period to period that is often lacking in interest rate forecasts based on econometric models of the future. This lets you focus on exposure to basis risk, not the unique specifics of any given forecast.
The MPS Solution for Quantifying Basis Risk
MPS Smart Ramps provide interest rate projections of non-linear rate ramps and yield curve shape changes that are stable and reliable tests for income related IRR analysis and business plan evaluations. They bridge the gap between naive rate shocks and ramps (which are too simplistic because all interest rates move at the same speed) and econometric modeling based interest rate forecasts (which often have inconsistent or confusing predictions).
MPS Smart Ramps feature:
- Monthly rate projections are based on advanced statistical analysis of historic rate patterns.
- Non-linear rate ramp projections of 12 month scenarios from -200 bp to +400 bp
- Yield curve shape change projections for 1 steeper curve and 4 flatter curves
- 10 Treasury yield curve points, 4 LIBOR curve points, and 6 other rates are projected
- Web based delivery and fast production – available within 5 business days of month end