Basis Swap

Publication Date :

15 Mar, 2025

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Table of Contents

What Is a Basis Swap?

A basis swap (or basis rate swap) refers to an interest rate swap in which two parties manage interest rate risk by exchanging variable rates attached to different benchmarks. It manages liquidity and interest rate risk a company faces because of its mismatched borrowing and lending rates.

It forms a vital tool to hedge against money market benchmarks, yield curve points and different indices. The counterparties of the swap can tailor the terms of the basis rate swap. Plain vanilla swap forma is the most common type of swap in which a fixed interest rate gets exchanged for a floating interest rate.

Key Takeaways

A basis swap is an interest rate exchange whereby two parties handle their interest rate risk through trading variable rates derived from several benchmarks.
It controls the interest rate and liquidity risk that a business undergoes due to its mismatched funding and borrowing rates.
It results due to parallelism between floating and fixed interest rates can lead to unexpected cash flow volatility and monetary losses.
It is the basis of exchange cash flows in the equitable interest rate benchmark having different maturities, in contrast, interest rate swap is the different interest rates from the exchange cash flows.

Basis Swap Explained

A basis swap involves the exchange of cash flows between counterparties as per the discrepancies in indices of two floating rates like LIBOR & EURIBOR. It helps to manage interest rate risk amongst benchmarks exchanging flow of cash pe the difference among the floating rates. It provides companies with means to streamline their lending and borrowing rates, thereby decreasing exposure to any volatility. The floating rate per one index has to be paid by one participant, and another participant receives the floating rate per another index.

It has implications like mitigating basis risk arising when different factors drive cash flows correlating less than unity. Basis rate swaps also offer portfolio diversification, arbitrage opportunities, liquidity and risk management. They have become crucial tools in fixed-income markets regarding interest risk management. The modern financial market relies on basis rate swaps to leverage yield differences present in the market and mitigate risk related to interest rate volatility.

Basis Risk in Basis Swap

The risk is due to the parallelism between the floating and fixed interest rates, making them deviate from the desired or expected level. Furthermore, it arises because of various factors like variations in credit risk, liquidity, market conditions, and miscellaneous factors. Hence, it can lead to sudden volatility in cash flow and monetary losses to the counterparties involved.

The risk can be reduced if the parties involved deploy various strategies. The strategies can range from continuous monitoring and changing the swap agreement to spreading counterparty risk through various financial instruments like futures or hedging options. Moreover, the strategy must also involve remaining aware of the new regulations and market trends.

Examples

Let us use a few examples to understand the topic.

Example #1

An online article published on 30 June 2023 discusses the CME group's intention of fully repaying clearing term SOFR swaps derived from the difference in term and overnight SOFR interest rates. At present, CME clears only overnight SOFR swaps and not term SOFR. Therefore, such a move will help banks handle risk by offloading overnight versus term SOFR basis risk owing to client hedging.

Nevertheless, the CME initiative has to face many hurdles as the US Alternative Reference Rates Committee (ARRC) and regulators are afraid that a complete working market concerning the term SOFR derivatives could belittle the Libor transformation. Further, the interdealer market has banned the trading term SOFR by large banks. Regional banks could benefit from clearing term SOFR basis rate swaps, making it cheaper by drawing large participants such as hedge funds.

Example # 2

Let us assume that the Old York Stock Exchange floor conducts the basis rate swap. Investors have been holding bond A, which is listed and pays him a fixed 6% coupon. Nevertheless, investor A likes bond B's interest rate risk profile, which is non-exchange listed and gives a 7% bond yield. Investor B has Bond B and wants the exchange-listed Bond A.

Hence, both investors A and B agree to a basis rate swap. In the agreement, investor A pays a fixed charge to receive the coupon of 7% on bond B. On the contrary, investor B pays another fee for the coupon of 6% on bond A. As a result, both could exchange their interest rate risk profiles without directly buying each other's bonds.

Basis Swap Vs Interest Rate Swap

Let us use a table to understand the differences between the two:

Basis Swap	Interest Rate Swap
The basis of exchange cash flows is the equitable interest rate benchmark having different maturities.	Different interest rates from the exchange cash flows.
Takes care of both liquidity as well as interest rate risk.	Manages only interest rate risk.
Banks and related financial institutions often use it to handle funding costs.	Lenders and borrowers usually use it as a tool in managing their interest rate risk.
It has been less attractive for quick adjustment of positions because of its less liquid character.	It has been highly attractive for quick adjustment of positions because of its more liquid character.
Various terms, like payment schedules, can be customized by counterparties.	It comprises of exchanging of floating for fixed rates and vice versa.
Helps reduce basis risks arising out of factors less than one driving cash flows.	It has no role in mitigating basic risk.
It mostly gets used in cases of major differences or uncertainty in derived financial instrument's price.	Becomes popular at times of expected interest rate directions.