What Is a Basis Rate Swap Definition Example and Basis Risk

Basis Rate Swap – Definition, Example, and Basis Risk

Basis Rate Swap

A basis rate swap (or basis swap) is a swap agreement between two parties to swap variable interest rates based on different money market reference rates. The goal is for a company to limit interest rate risk resulting from different lending and borrowing rates.

For example, a company lends money at a variable rate tied to the London Interbank Offered Rate (LIBOR), but borrows money based on the Treasury Bill (T-Bill) rate. This difference (spread) leads to interest rate risk, which could result in investment losses. By entering into a basis rate swap, the company exchanges the T-Bill rate for the LIBOR rate and eliminates this interest rate risk.

Key Takeaways

– A basis rate swap (also known as a basis swap) is an agreement between two parties to swap variable interest rates based on different money market reference rates.

– It helps a company hedge against interest rate risk arising from different lending and borrowing rates.

– The two parties to the contract (counterparties) can customize the swap terms, including payment schedules.

– A common form is a plain vanilla swap, where a floating interest rate is exchanged for a fixed rate or vice versa.

Understanding Basis Rate Swaps

Basis rate swaps involve the exchange of floating interest rates between financial assets. They allow the exchange of variable interest rate payments based on two different rates, typically for liquidity purposes.

Usually, basis rate swap cash flows are netted based on the rate difference, unlike currency swaps where all cash flows include interest and principal payments.

Basis Risk

Basis rate swaps help mitigate basis risk, a type of risk associated with imperfect hedging. It arises when there are different factors affecting payable and receivable cash flows, with less than perfect correlation.

Basis rate swaps reduce potential gains or losses from basis risk and are primarily used for hedging. However, some entities use these contracts to express directional views in rates.

Example of Basis Rate Swaps

Though customized, popular basis rate swaps include LIBOR/LIBOR, Fed funds rate/LIBOR, Prime rate/LIBOR, and Prime rate/Fed funds rate. Payments are often scheduled quarterly.

In a LIBOR/LIBOR swap, one counterparty may receive three-month LIBOR and pay six-month LIBOR, while the other does the opposite.

Special Considerations

A common form of interest rate swap is the plain vanilla swap. It describes an agreement where a floating rate is exchanged for a fixed rate or vice versa. It helps hedge a floating rate exposure or benefit from declining rates.

The notional principal remains the same throughout the swap, and interest payments are netted. A financial institution may engage in a plain vanilla interest rate swap to hedge exposure or transition from a fixed to a floating rate.