Managing the risk of loans with basis risk: sell, hedge, or do nothing?
AbstractIndividual 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.
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Bibliographic InfoPaper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2000-25.
Date of creation: 2000
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2001-02-08 (All new papers)
- NEP-CFN-2001-02-08 (Corporate Finance)
- NEP-IAS-2001-02-08 (Insurance Economics)
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