How does basis risk arise when a corporate treasurer hedges floating-rate debt with FRAs?

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AcadiFi · Accepted Answer

Yes, and it's the textbook definition of basis risk. Basis risk is the residual exposure that remains when the hedge instrument's reference rate doesn't move in perfect lockstep with the exposure you're trying to hedge.

Consider Brightstone Manufacturing with $50 million of commercial paper repricing every 90 days at Term SOFR plus a spread. The treasurer buys a 3x6 FRA linked to compounded SOFR in arrears. Both rates sit on the same underlying SOFR curve, but they aren't the same rate. Term SOFR is set at the beginning of the period from a forward-looking CME auction; compounded SOFR is backward-looking, averaging daily realized rates.

If the Fed surprises markets mid-period with an unexpected hike, compounded SOFR will absorb the shock immediately while the Term SOFR fix for the next period will have already locked in before the hike. The FRA payoff reflects actual realized path, but the CP reset reflects the expectation embedded in Term SOFR. The two differ by the amount of the surprise.

Other basis sources include tenor basis (3-month vs 1-month rates can diverge during stress), cross-currency basis if hedging foreign-currency debt, and reset-date basis if the FRA fixes a few days off the CP reset calendar. In calm markets basis is trivial. In 2020 during the LIBOR dislocation, basis blew out dramatically. Good hedging means matching reference rate, tenor, and reset dates as closely as possible.

How does basis risk arise when a corporate treasurer hedges floating-rate debt with FRAs?

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