Default risk and the effective duration of bonds

Basis risk is the risk attributable to uncertain movements in the spread between yields associated with a particular financial instrument or class of instruments, and a reference interest rate over time. There are seven types of basis risk: Yields on 1) Long-term versus short-term financial instruments, 2) Domestic currency versus foreign currencies, 3) Liquid versus illiquid investments, 4) Bonds with higher or lower sensitivity to changes in interest rate volatility, 5) Taxable versus tax-free instruments, 6) Spot versus futures contracts and 7) Default-free versus non-default-free securities. Basis risk makes it difficult for the fixed-income portfolio manager to measure the portfolio's exposure to interest rate risk, heightens the anxiety of traders and arbitrageurs who are hedging their investments, and compounds the financial institution's problem of matching assets and liabilities. Much attention has been paid to the first type of basis risk. In recent years, attention has turned toward understanding the relation between credit risk and duration. The authors focus on that, emphasizing the importance of taking credit risk into account when computing measures of duration. The consensus of all work in this area is that credit risk shortens the effective duration of corporate bonds. The authors estimate how much durations shorten because of credit risk, basing their estimates on observable data and easily estimated bond pricing parameters.