A thrift has funded 10 percent fixed-rate assets with variable-rate liabilities at LIBOR + 2 (L + 2) percent.A bank has funded variable-rate assets with fixed-rate liabilities at 6 percent.The bank's variable-rate assets earn LIBOR + 1 (L + 1) percent.The thrift and the bank have reached agreement on an interest-rate swap with the fixed-rate swap payment at 6 percent and the variable-rate swap payment at LIBOR. Assume that the thrift variable-rate liabilities are CDs indexed to some domestic rate.Which of the following statements describes the hedge characteristics of the above example?
A)The thrift is exposed to basis risk because the CD rates may not be perfectly correlated with the LIBOR rates.
B)Only the bank is fully hedged.
C)The thrift is exposed to basis risk if the credit/default risk premium on the thrift's CDs increases over time.
D)All of the options.
E)The thrift is exposed to basis risk because the CD rates may not be perfectly correlated with the LIBOR rates, and only the bank is fully hedged.

Question

Quizplus · Accepted Answer

The thrift is exposed to basis risk because its variable-rate liabilities are indexed to a domestic rate which may not be perfectly correlated with LIBOR. Additionally, if the credit/default risk premium on the thrift's CDs increases over time, it will also be exposed to basis risk. The bank is fully hedged because its variable-rate assets are swapped for fixed-rate liabilities at 6 percent.

A Thrift Has Funded 10 Percent Fixed-Rate Assets with Variable-Rate