Basis swap

A type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates.

Investopedia Says:
For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk.

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Swap agreement involving exchange of two floating rate financial instruments denominated in the same currency, one pegged to one reference rate and the other tied to a second reference rate. Contrast with Currency Swap and Interest Rate Swap.

A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A floating-floating interest rate swap under which the floating rate payments is referenced to different bases.

Usage of basis swaps for hedging

Basis risk occurs for positions that have at least one paying and one receiving stream of cash flows that are driven by different factors and the correlation between those factors are less than one. Entering into a Basis Swap may offset the effect of gains or losses resulted from changes in the basis, thus, reducing basis risk. Trading in PRDC usually involves using Basis Swaps to hedge against basis risk between JPY LIBOR and EUR LIBOR yields. Hence basis swaps can be used to hedge

1. against exposure to currency fluctuations (for example, 1 mo USD LIBOR for 1 mo GBP LIBOR)
2. against one index in the favor of another (for example, 1 mo USD T-bill for 1 mo USD LIBOR)
3. different points on a yield curve (for example, 1 mo USD LIBOR for 6 mo USD LIBOR)

See also

• Interest rate swap

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