# Basis risk

1. *Hedging*.

Basis risk includes the risk of an unfavourable change in the relationship between the price of a derivative and the market value of an underlying asset or liability being hedged.

For example resulting in a smaller profit being enjoyed on a hedging derivative, than the loss suffered on the underlying exposure.

Good hedge design therefore seeks to eliminate or minimise basis risk in the hedged position, so far as practicable.

2. *Funding*.

Basis risk also arises in bank funding.

It arises when the reference rates used for the pricing of assets and their funding are different.

For example, a UK bank's mortgage assets might be priced by reference to BBR (the Bank of England's Official Bank Rate) plus a margin, while the bank's funding is priced at LIBOR (plus a margin).

The bank's net interest income depends on the differential between BBR and LIBOR.

Basis risk - in this context - means the risk of adverse changes in the differential between BBR and LIBOR. An adverse change might compress the bank's net interest income, or even result in losses.