Interest rate basis risks in the Libor and RFR worlds

Basis risk arises when investors' assets and liabilities reference different floating rates. In this box, we first describe how the transition from Libor to the new risk-free rates (RFRs) changed Libor-related basis risks. We then explain how the differences between various reference rates in the RFR world give rise to new basis risks.

While mitigating Libor-related basis risks, the transition gave rise to Libor-RFR basis risks. One example of old Libor-related basis risks stems from different tenors of the reference rate: eg six-month Libor versus three-month Libor (Graph B1.A). Since RFRs track actual rates continuously, they eliminate this basis risk. However, basis risks can arise from the difference between Libor and RFRs when market participants have legacy Libor exposures. For example, suppose a bank has assets referencing Libor (eg legacy Libor loans) and liabilities referencing the standard averaged RFR, which compounds the overnight rates over the coupon period, ie "in arrears". The bank is then exposed to the basis between Libor and RFR in arrears. This basis could be substantial when the future path of interest rates is uncertain, as illustrated in the second half of 2022 (Graph B1.B).

New basis risks arise from the differences between the new reference rates and the standard RFR in arrears. The first type of new basis risk stems from the difference between RFR in arrears and in advance. RFR in arrears uses overnight rates prevailing during the current coupon period, whereas RFR in advance compounds past daily overnight rates. This difference creates a basis, which is positive when rates go up and is negative when rates go down (Guggenheim and Schrimpf (2020)). Using one of the standard market conventions for coupon calculation (three-month period), this basis reached about –150 basis points during the rate-cutting cycle in the second quarter of 2020 and +150 basis points during the rate-hiking cycle in the second half of 2022 (Graph B1.C, light blue line).

The second type of new basis risk arises from the difference between term RFR and RFR in arrears. In contrast to the backward-looking nature of RFR in arrears, term RFR is a forward-looking rate based on RFR derivatives such as futures (eg CME term SOFR). The basis between term RFR and RFR in arrears is thus related to the term premium: it is positive if expected future interest rates are higher than subsequent realisations, and negative otherwise. This basis spiked above 100 basis points when market participants expected monetary policy tightening before the Covid19 shock in March 2020 and dipped into the negative domain when market participants temporarily foresaw a flatter policy rate path in May 2022 (Graph B1.C, dark blue line).

The third type of new basis risks stems from the difference between credit-sensitive term rates and RFR in arrears. This basis is related to the evolution of banks' term funding costs. The credit risk component of the basis is typically positive and spikes in stress times, as illustrated by the Covid turmoil in March 2020 (Graph B1.C, yellow line).

The views expressed are those of the authors and do not necessarily reflect those of the Bank for International Settlements.