Basis swap

Basis swap
See also

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[edit]

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[edit]

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.

Footnotes[edit]

  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

References[edit]

Author: Artur Bućko