Basis swap
Barron's Banking Dictionary:
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Basis Swap
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.
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Basis swap
Investopedia Financial Dictionary:
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Basis Rate 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.
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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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Basis swap
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A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A basis swap functions as a floating-floating interest rate swap under which the floating rate payments are 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 resulting from changes in the basis, thus reducing basis risk.
- against exposure to currency fluctuations (for example, 1 mo USD LIBOR for 1 mo GBP LIBOR)
- against one index in the favor of another (for example, 1 mo USD T-bill for 1 mo USD LIBOR)
- different points on a yield curve (for example, 1 mo USD LIBOR for 6 mo USD LIBOR)
Basis swaps in energy commodities
In energy markets, a basis swap is a swap on the price differential for a product and a major index product (e.g. Brent Crude or Henry Hub gas).
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Barron's Banking Dictionary
Dictionary of Banking Terms. Copyright © 2006 by Barron's Educational Series, Inc. All rights reserved.
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