Managing the Risk of Loans with Basis Risk: Sell, Hedge, or Do Nothing?
Larry D. Wall and Milind M. Shrikhande
Working Paper 2000-25
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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.
JEL classification: G21
Key words: loan sales, hedging, risk management
The authors thank Bill Emmons, Joe Sinkey, and Steve Smith for helpful comments and suggestions, and Paul Gilson and Dan Waggoner for excellent research assistance. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
Please address questions regarding content to Larry D. Wall, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303, 404-498-8937, firstname.lastname@example.org, or Milind M. Shrikhande, Georgia State University and Federal Reserve Bank of Atlanta, 104 Marietta Street N.W., Atlanta, Georgia 30303, 404-498-8974, 404-498-8810 (fax), email@example.com.