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What are gap exposure and Basis risk?
1) Gap exposure is where there is an interest rate risk between the interest-bearing assets & interest-bearing liabilities. The more the gap between both of them then, there is a gap exposure.
This is what I read but I couldn’t understand that what does it mean by different bases determined for variable interest rates on assets & liabilities, would you please explain this?
2) Basis risk is where even if interest-sensitive assets & interest-sensitive liabilities are matched, interest rate risk can arise if variable interest rates on assets & liabilities are determined on different bases (basis risk).
Gap exposure has nothing to do with basis risk.
If you borrow money you will pay interest, and if you have money on deposit you will receive interest. The interest banks pay on deposits is lower than the interest that they charge on borrowings (because they make a profit on the difference). That is what the gap is, and if interest rates overall go up then this gap/difference gets bigger.
Basis risk is something completely different – it is the difference between the actual interest rate and the equivalent interest rate on interest rate futures. I would not worry too much about that because it is not examinable until Paper AFM ? )
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