Definition of Basis risk

Basis risk

The uncertainty about the basis at the time a hedge may be lifted. Hedging substitutes basis risk for
price risk.

Agency basis

A means of compensating the broker of a program trade solely on the basis of commission
established through bids submitted by various brokerage firms. agency incentive arrangement. A means of
compensating the broker of a program trade using benchmark prices for issues to be traded in determining
commissions or fees.

Bank discount basis

A convention used for quoting bids and offers for treasury bills in terms of annualized
yield , based on a 360-day year.

Bankruptcy risk

The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk.

Basis

Regarding a futures contract, the difference between the cash price and the futures price observed in the
market. Also, it is the price an investor pays for a security plus any out-of-pocket expenses. It is used to
determine capital gains or losses for tax purposes when the stock is sold.

Basis point

In the bond market, the smallest measure used for quoting yields is a basis point. Each percentage
point of yield in bonds equals 100 basis points. basis points also are used for interest rates. An interest rate of
5% is 50 basis points greater than an interest rate of 4.5%.

Basis price

Price expressed in terms of yield to maturity or annual rate of return.

Bond-equivalent basis

The method used for computing the bond-equivalent yield.

Business risk

The risk that the cash flow of an issuer will be impaired because of adverse economic
conditions, making it difficult for the issuer to meet its operating expenses.

Call risk

The combination of cash flow uncertainty and reinvestment risk introduced by a call provision.

Commercial risk

The risk that a foreign debtor will be unable to pay its debts because of business events,
such as bankruptcy.

Company-specific risk

Related: Unsystematic risk

Completion risk

The risk that a project will not be brought into operation successfully.

Counterparty risk

The risk that the other party to an agreement will default. In an options contract, the risk
to the option buyer that the option writer will not buy or sell the underlying as agreed.
Country economic risk Developments in a national economy that can affect the outcome of an international
financial transaction.

Country financial risk

The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.

Country risk General

Level of political and economic uncertainty in a country affecting the value of loans or
investments in that country.

Credit risk

The risk that an issuer of debt securities or a borrower may default on his obligations, or that the
payment may not be made on a negotiable instrument. Related: Default risk

Cross-border risk

Refers to the volatility of returns on international investments caused by events associated
with a particular country as opposed to events associated solely with a particular economic or financial agent.

Currency risk

Related: Exchange rate risk

Currency risk sharing

An agreement by the parties to a transaction to share the currency risk associated with
the transaction. The arrangement involves a customized hedge contract embedded in the underlying
transaction.

Default risk

Also referred to as credit risk (as gauged by commercial rating companies), the risk that an
issuer of a bond may be unable to make timely principal and interest payments.

Discounted basis

Selling something on a discounted basis is selling below what its value will be at maturity,
so that the difference makes up all or part of the interest.

Diversifiable risk

Related: unsystematic risk.

Economic risk

In project financing, the risk that the project's output will not be salable at a price that will
cover the project's operating and maintenance costs and its debt service requirements.

Equilibrium market price of risk

The slope of the capital market line (CML). Since the CML represents the
return offered to compensate for a perceived level of risk, each point on the line is a balanced market
condition, or equilibrium. The slope of the line determines the additional return needed to compensate for a
unit change in risk.

Event risk

The risk that the ability of an issuer to make interest and principal payments will change because
of rare, discontinuous, and very large, unanticipated changes in the market environment such as (1) a natural
or industrial accident or some regulatory change or (2) a takeover or corporate restructuring.

Exchange rate risk

Also called currency risk, the risk of an investment's value changing because of currency
exchange rates.

Exchange risk

The variability of a firm's value that results from unexpected exchange rate changes or the
extent to which the present value of a firm is expected to change as a result of a given currency's appreciation
or depreciation.

Fallout risk

A type of mortgage pipeline risk that is generally created when the terms of the loan to be
originated are set at the same time as the sale terms are set. The risk is that either of the two parties, borrower
or investor, fails to close and the loan "falls out" of the pipeline.

Financial risk

The risk that the cash flow of an issuer will not be adequate to meet its financial obligations.
Also referred to as the additional risk that a firm's stockholder bears when the firm utilizes debt and equity.

Firm-specific risk

See:diversifiable risk or unsystematic risk.

Fixed price basis

An offering of securities at a fixed price.

Flat price risk

Taking a position either long or short that does not involve spreading.

Flow-through basis

An account for the investment credit to show all income statement benefits of the credit
in the year of acquisition, rather than spreading them over the life of the asset acquired.

Force majeure risk

The risk that there will be an interruption of operations for a prolonged period after a
project finance project has been completed due to fire, flood, storm, or some other factor beyond the control
of the project's sponsors.

Foreign exchange risk

The risk that a long or short position in a foreign currency might have to be closed out
at a loss due to an adverse movement in the currency rates.

Formula basis

A method of selling a new issue of common stock in which the SEC declares the registration
statement effective on the basis of a price formula rather than on a specific range.

Funding risk

Related: interest rate risk

Geographic risk

risk that arises when an issuer has policies concentrated within certain geographic areas,
such as the risk of damage from a hurricane or an earthquake.

Herstatt risk

The risk of loss in foreign exchange trading that one party will deliver foreign exchange but the counterparty financial institution will fail to deliver its end of the contract. It is also referred to as settlement risk.

Idiosyncratic Risk

Unsystematic risk or risk that is uncorrelated to the overall market risk. In other words,
the risk that is firm specific and can be diversified through holding a portfolio of stocks.

Inflation risk

Also called purchasing-power risk, the risk that changes in the real return the investor will
realize after adjusting for inflation will be negative.

Insolvency risk

The risk that a firm will be unable to satisfy its debts. Also known as bankruptcy risk.

Interest rate risk

The risk that a security's value changes due to a change in interest rates. For example, a
bond's price drops as interest rates rise. For a depository institution, also called funding risk, the risk that
spread income will suffer because of a change in interest rates.

Liquidity risk

The risk that arises from the difficulty of selling an asset. It can be thought of as the difference
between the "true value" of the asset and the likely price, less commissions.

Market price of risk

A measure of the extra return, or risk premium, that investors demand to bear risk. The
reward-to-risk ratio of the market portfolio.

Market risk

risk that cannot be diversified away. Related: systematic risk

Mortgage-pipeline risk

The risk associated with taking applications from prospective mortgage borrowers
who may opt to decline to accept a quoted mortgage rate within a certain grace period.

Nondiversifiable risk

risk that cannot be eliminated by diversification.

Nonsystematic risk

Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also
called unique risk or diversifiable risk. Systematic risk refers to risk factors common to the entire economy.

Operating risk

The inherent or fundamental risk of a firm, without regard to financial risk. The risk that is
created by operating leverage. Also called business risk.

Overnight delivery risk

A risk brought about because differences in time zones between settlement centers
require that payment or delivery on one side of a transaction be made without knowing until the next day
whether the funds have been received in an account on the other side. Particularly apparent where delivery
takes place in Europe for payment in dollars in New York.

Political risk

Possibility of the expropriation of assets, changes in tax policy, restrictions on the exchange of
foreign currency, or other changes in the business climate of a country.

Price risk

The risk that the value of a security (or a portfolio) will decline in the future. Or, a type of
mortgage-pipeline risk created in the production segment when loan terms are set for the borrower in advance
of terms being set for secondary market sale. If the general level of rates rises during the production cycle, the
lender may have to sell his originated loans at a discount.

Price value of a basis point (PVBP)

Also called the dollar value of a basis point, a measure of the change in
the price of the bond if the required yield changes by one basis point.

Product risk

A type of mortgage-pipeline risk that occurs when a lender has an unusual loan in production or
inventory but does not have a sale commitment at a prearranged price.

Purchasing-power risk

Related: inflation risk

Rate risk

In banking, the risk that profits may decline or losses occur because a rise in interest rates forces up
the cost of funding fixed-rate loans or other fixed-rate assets.

Regulatory pricing risk

risk that arises when regulators restrict the premium rates that insurance companies
can charge.

Reinvestment risk

The risk that proceeds received in the future will have to be reinvested at a lower potential
interest rate.

Residual risk

Related: unsystematic risk

Reverse price risk

A type of mortgage-pipeline risk that occurs when a lender commits to sell loans to an
investor at rates prevailing at application but sets the note rates when the borrowers close. The lender is thus
exposed to the risk of falling rates.

Risk

Typically defined as the standard deviation of the return on total investment. Degree of uncertainty of
return on an asset.

Risk-adjusted profitability

A probability used to determine a "sure" expected value (sometimes called a
certainty equivalent) that would be equivalent to the actual risky expected value.

Risk arbitrage

Speculation on perceived mispriced securities, usually in connection with merger and
acquisition deals. Mike Donatelli, John Demasi, Frank Cohane, and Scott Lewis are all hardcore arbs. They
had a huge BT/MCI position in the summer of 1997, and came out smelling like roses.

Risk averse

A risk-averse investor is one who, when faced with two investments with the same expected
return but two different risks, prefers the one with the lower risk.

Risk classes

Groups of projects that have approximately the same amount of risk.

Risk controlled arbitrage

A self-funding, self-hedged series of transactions that generally utilize mortgage
securities as the primary assets.

Risk indexes

Categories of risk used to calculate fundamental beta, including (1) market variability, (2)
earnings variability, (3) low valuation, (4) immaturity and smallness, (5) growth orientation, and (6) financial risk.

Risk lover

A person willing to accept lower expected returns on prospects with higher amounts of risk.

Risk management

The process of identifying and evaluating risks and selecting and managing techniques to
adapt to risk exposures.

Risk neutral

Insensitive to risk.

Risk prone

Willing to pay money to transfer risk from others.

Risk premium

The reward for holding the risky market portfolio rather than the risk-free asset. The spread
between Treasury and non-Treasury bonds of comparable maturity.

Risk premium approach

The most common approach for tactical asset allocation to determine the relative
valuation of asset classes based on expected returns.

Riskless rate

The rate earned on a riskless investment, typically the rate earned on the 90-day U.S. Treasury Bill.

Riskless rate of return

The rate earned on a riskless asset.

Riskless arbitrage

The simultaneous purchase and sale of the same asset to yield a profit.

Riskless or risk-free asset

An asset whose future return is known today with certainty. The risk free asset is
commonly defined as short-term obligations of the U.S. government.

Risky asset

An asset whose future return is uncertain.

Risk-adjusted

return Return earned on an asset normalized for the amount of risk associated with that asset.

Risk-free asset

An asset whose future return is known today with certainty.

Risk-free rate

The rate earned on a riskless asset.

Shortfall risk

The risk of falling short of any investment target.

Sovereign risk

The risk that a central bank will impose foreign exchange regulations that will reduce or
negate the value of FX contracts. Also refers to the risk of government default on a loan made to it or
guaranteed by it.

Specific risk

See:unique risk.

Systematic risk

Also called undiversifiable risk or market risk, the minimum level of risk that can be
obtained for a portfolio by means of diversification across a large number of randomly chosen assets. Related:
unsystematic risk.

Systematic risk principle

Only the systematic portion of risk matters in large, well-diversified portfolios.
The, expected returns must be related only to systematic risks.

Undiversifiable risk

Related: Systematic risk

Unique risk

Also called unsystematic risk or idiosyncratic risk. Specific company risk that can be eliminated
through diversification. See: diversifiable risk and unsystematic risk.

Unsystematic risk

Also called the diversifiable risk or residual risk. The risk that is unique to a company
such as a strike, the outcome of unfavorable litigation, or a natural catastrophe that can be eliminated through diversification.
Related: Systematic risk

Value-at-Risk model (VAR)

Procedure for estimating the probability of portfolio losses exceeding some
specified proportion based on a statistical analysis of historical market price trends, correlations, and volatilities.

Volatility risk

The risk in the value of options portfolios due to the unpredictable changes in the volatility of
the underlying asset.

Cost basis

An asset’s purchase price, plus costs associated with the purchase, like installation fees, taxes, etc.

accrual-basis accounting

Well, frankly, accrual is not a good descriptive
term. Perhaps the best way to begin is to mention that accrual-basis
accounting is much more than cash-basis accounting. Recording only the
cash receipts and cash disbursement of a business would be grossly
inadequate. A business has many assets other than cash, as well as
many liabilities, that must be recorded. Measuring profit for a period as
the difference between cash inflows from sales and cash outflows for
expenses would be wrong, and in fact is not allowed for most businesses
by the income tax law. For management, income tax, and financial
reporting purposes, a business needs a comprehensive record-keeping
system—one that recognizes, records, and reports all the assets and liabilities
of a business. This all-inclusive scope of financial record keeping
is referred to as accrual-basis accounting. Accrual-basis accounting
records sales revenue when sales are made (though cash is received
before or after the sales) and records expenses when costs are incurred
(though cash is paid before or after expenses are recorded). Established
financial reporting standards require that profit for a period
must be recorded using accrual-basis accounting methods. Also, these
authoritative standards require that in reporting its financial condition a
business must use accrual-basis accounting.

Asset-specific Risk

The amount of total risk that can be eliminated by diversification by
creating a portfolio. Also known as company-specific risk or
unsystematic risk.

Basis Point

One one-hundredth of one percent

Companyspecific Risk

See asset-specific risk

Market Risk

The amount of total risk that cannot be eliminated by portfolio
diversification. The risk inherent in the general economy as a
whole. Also known as systemic risk.

Risk Premium

The additional rate of return required on a risky project
(investment) when compared to a risk-free project (investment)

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