What Is a Basis Rate Swap?
A basis rate swap (or basis swap) is a type of swap agreement in which two parties swap variable interest rates based on different money market reference rates, usually to limit the interest-rate risk that a company faces as a result of having differing lending and borrowing rates.
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, so by entering into a basis rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk.
Understanding Basis Rate Swap
Basis rate swaps are a form of floating for floating interest rate swaps. These types of swaps allow the exchange of variable interest rate payments that are based on two different interest rates. This type of contract allows an institution to turn one floating-rate into another and are generally used for exchanging liquidity.
Usually, basis rate swap cash flows are netted based on the difference between the two rates of the contact. This is unlike typical currency swaps where all cash flows include interest and principal payments.
Basis rate swaps help to mitigate (hedge) basis risk, which is a type of risk associated with imperfect hedging. This type of risk arises when an investor or institution has a position in a contract or security that has at least one stream of payable cash flows and at least one stream of receivable cash flows, where the factors affecting those cash flows are different than one another, and the correlation between them is less than one.
Basis rate swaps can help reduce the potential gains or losses arising from basis risk, and because this is their primary purpose, are typically used for hedging. But certain entities do use these contracts to express directional views in rates, such as the direction of LIBOR-based spreads, views on consumer credit quality, and even the divergence of the Fed funds effective rate versus the Fed funds target rate.
Real-World Examples of Basis Rate Swaps
While these types of contracts are customized between two counterparties over the counter (OTC), and not exchange-traded, four of the more popular basis rate swaps include:
- fed funds rate/LIBOR
- prime rate/LIBOR
- prime rate/fed funds rate
Payments on these types of swaps will also be customized, but it is prevalent for the payments to occur on a quarterly schedule.
In a LIBOR/LIBOR swap, one counterparty may receive three-month LIBOR and pay six-month LIBOR while the other counterparty does the opposite, or one counterparty may receive one-month USD LIBOR and pay one-month GBP LIBOR while the other does the opposite.