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Managing the risk of loans with basis risk: sell, hedge, or do nothing?

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  • Milind M. Shrikhande
  • Larry D. Wall

Abstract

Individual loans contain a bundle of risks including credit risk and interest rate risk. This paper focuses on the general issue of banks? management of these various risks in a model with costly loan monitoring and convex taxes. The results suggest that if the hedge is not subject to basis risk, then hedging dominates a strategy of ?do nothing.? Whether hedging dominates loan sales depends on whether it induces reduced monitoring, the net benefit of monitoring, and the reduced tax burden of eliminating all risk via selling. If the hedge is subject to basis risk, then a ?do nothing? strategy may dominate the hedging and loan sales strategy for risk neutral banks. A number of empirical implications follow from the analytical and numerical results in the paper.

Suggested Citation

  • Milind M. Shrikhande & Larry D. Wall, 2000. "Managing the risk of loans with basis risk: sell, hedge, or do nothing?," FRB Atlanta Working Paper 2000-25, Federal Reserve Bank of Atlanta.
    • Handle: RePEc:fip:fedawp:2000-25
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    References listed on IDEAS

    as
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    Cited by:

    1. Heidorn, Thomas & Buschmann, Christian, 2014. "The liquidity reserve funding and management strategies," Frankfurt School - Working Paper Series 210, Frankfurt School of Finance and Management.

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    More about this item

    Keywords

    Loan sales; Hedging (Finance); Risk management;
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