Basis swap

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Basis swap - also named as basis rate swap, is one of the types of swap agreements.
A swap is an agreement thanks to which two parties can exchange their cash flows or liabilities coming from different financial instruments. A lot of swaps involve money rates originally regulated by the government or financial institutions, but the monetary instrument can be almost anything. In the swap there are two cash flows, one which is fixed amount of transferred money and the second one that varies (because of index prices, floating currency exchange rate and benchmark interest rate)[1].

Thanks to basis rate swap its two sides exchange fluctuating interest rates. Which are created due to varying reference rates on money markets. Basis rate swap is generally used by financial institutions to regulate risk of the interest rates. That risk is created when a corporation's lending rate is different from its borrowing rate.

For Instance

An institution is lending cash to clients at a changeable rate basing on the London Interbank Offer Rate (LIBOR)[2] and, at the same time, that institution borrows cash at rate based on the Treasury Bill rate[3]. So, that exact difference between those rates leads to the interest-rate risk. That's why by using basis swap, institution can exchange the T-Bill rate for the LIBOR rate, and eliminate that risk.

Floating for Floating nature

Basis swaps are one of the forms of floating for floating interest rate swaps. Those kind of swaps enables to transfer changeable interest rate remittances that are based on two alternative interest rates. It enables a party of agreement to change floating-rate. In contrast to currency swaps where flows contain interest or principal payments, in general rate swap flows are compensated on the basis of the difference of two contact rates. As in above instance, it would be the size of LIBOR deducted from T-Bill rate.

Basis rate swap is a tool used for moderation of basis risk. This kind of risk shows up, in a situation, when a corporation, investor or government financial institution takes part in at least two cash flows. One of them is receivable and another one is payable. The factors which have an effect on those flows are different from each other, and have correlation between each other. Rate swap is a proper tool used in this situation, because its primary purpose is to decrease possible gain or loss emerging from basis risk[4].

Basis rate swaps are commonly confused with general cross currency swaps and diff swaps[5]:

  • General cross currency swaps differentiation. The aspect that differs basis swaps from general cross swaps is the floating for floating nature. To be precise, cross currency swap doesn't have to be floating for floating type and basis swap doesn't have to base on two, different currencies, and currency swap does.
  • Diff swaps differentiation. There is a similar difference between basis swap and diff swap as in the previous point. The diff swap insinuates payments of cash flows in two currencies.

Examples of Basis swap

  • A basis swap is a type of interest rate swap used to exchange floating rate payments for a fixed rate payment on a notional amount. This type of swap is often used to convert a variable rate loan into a fixed rate loan, or vice versa.
  • In a basis swap, the two counterparties agree to exchange two streams of interest payments, known as legs. The floating rate leg pays an interest rate based on a reference rate such as LIBOR, while the fixed rate leg pays a predetermined rate.
  • For example, Company A may have a variable rate loan with a floating rate of 3% plus LIBOR. Company B may have a fixed rate loan at 5%. In order to hedge their respective loan rates, Company A and Company B may enter into a basis swap. Under the terms of the swap, Company A would pay Company B a fixed rate of 5%, while Company B would pay Company A the floating rate of 3% plus LIBOR.
  • In this example, Company A is exchanging a floating rate for a fixed rate, while Company B is exchanging a fixed rate for a floating rate. The terms of the basis swaps are usually negotiated between the two parties, and the swap is usually for a fixed period of time.

Advantages of Basis swap

Basis swap is one of the most popular types of swap agreements and it has many advantages. These include:

  • Reducing risk, as it allows parties to transfer interest rate risk between them;
  • Allowing parties to take advantage of different interest rate markets;
  • Having flexible maturities, allowing parties to customize the duration of the swap to their needs;
  • Allowing parties to hedge the interest rate exposure of their balance sheets against the changing markets;
  • Providing cost savings by acting as a substitute for other derivative products;
  • Providing flexibility to parties by allowing them to unwind the swap agreement before the maturity date.

Limitations of Basis swap

Basis swaps have certain limitations that should be considered before entering into an agreement. These include:

  • Counterparty Risk: As with any swap agreement, there is a risk that one of the parties may default on their obligations. This can lead to significant financial losses for the other party.
  • Credit Risk: The value of the swap agreement is dependent upon the creditworthiness of both parties. If either party has a poor credit rating, the swap agreement may be less profitable or even unprofitable.
  • Liquidity Risk: The basis swap is an illiquid asset and there is a risk that it may be difficult to exit the agreement when needed.
  • Exchange Rate Risk: The value of the swap agreement depends on the exchange rate between the two currencies, so there is a risk that fluctuations in the exchange rate could lead to unexpected losses.
  • Market Volatility Risk: The basis swap is sensitive to changes in market conditions, and there is a risk that losses could occur if the market moves in an unexpected direction.

Other approaches related to Basis swap

Basis swap is one of the types of swap agreements and there are several other approaches related to it. These include:

  • Interest rate swap - It is a financial derivative contract in which two parties agree to exchange future cash flows based on different interest rates.
  • Currency swap - It is a financial derivative contract in which two parties agree to exchange a series of cash flows denominated in two different currencies.
  • Credit default swap - It is a financial derivative contract in which two parties agree to exchange payments in the event of a credit event.
  • Total return swap - It is a financial derivative contract in which two parties agree to exchange the total return of an underlying asset.

In summary, there are several other approaches related to basis swaps, such as interest rate swaps, currency swaps, credit default swaps, and total return swaps. Each of these involve two parties agreeing to exchange future cash flows based on different rates or underlying assets.

Footnotes

  1. ↑ B. Coyle, (2001), p. 5-21,
  2. ↑ London Interbank Offer Rate., (2019),
  3. ↑ Treasury Bill Rate., (2019),
  4. ↑ H. Corb, (2012), p. 40-63,
  5. ↑ E. Benhamou, (2019), Swaps: basis swaps., p. 2


Basis swap — recommended articles
Credit instrument — Interest Rate Collar — Outright Forward — Swap Ratio — Forward Swap — Currency certificate — Forward points — Embedded derivative — Debt extinguishment

References

Author: Artur Bućko

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