Basis Risk in Liability-Hedging Strategies

Recent pricing dislocations in U.S. fixed-income markets have illustrated there is more to hedging a liability’s interest rate risk than simply matching its duration. Basis risk – in the context of liability hedging – is the risk that the changes in the market value of assets, designated as a hedge, will deviate from the changes in the value of the appropriate liability benchmark.

This paper provides Watson Wyatt’s perspective on how to address this aspect of managing a liability’s interest rate (and inflation1) risk.

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