What is a 'Zero Basis Risk Swap (ZEBRA)'

A zero basis risk swap (ZEBRA) is an interest rate swap agreement between a municipality and a financial intermediary. A swap is an agreement with two counterparties, where one party pays the other party a fixed interest rate, and receives a floating rate. This particular swap is considered zero-risk because the municipality receives a floating rate that is equal to the floating rate on their debt obligations.

The ZEBRA is also known as a "perfect swap" or "actual rate swap".

Breaking Down the 'Zero Basis Risk Swap (ZEBRA)'

Zero basis risk swaps entail the municipality paying a fixed rate of interest on a specified principal amount to the financial intermediary. In return, they receive a floating rate of interest from the financial intermediary. The floating rate received is equal to the floating rate on the outstanding debt initially issued by the municipality to the public.

Municipalities use these types of swaps to manage risk, as the swap creates more stable cash flows. If the floating rate on their debt rises, the floating rate they receive from the ZEBRA swap also rises. This helps avoid the situation where interest on debt rises but those higher interest charges are not offset by higher interest payments coming in.

The municipality always pays the fixed interest rate in a ZEBRA swap. This is what allows them to keep their cash flows stable; they know what they will be paying out, and also know that the floating rate they pay will be equally offset by the floating rate they receive. 

ZEBRA swaps are traded over-the-counter and can be for any amount agreed on by the municipality and the financial institution counterparty.

ZEBRA Example

A municipality has $10 million in floating rate debt at LIBOR plus 1%, with LIBOR at 2%. The municipality agrees to pay a fixed rate of 3.1% to a financial intermediary for a term agreed to by the parties. In exchange, the municipality receives floating interest rate payments of LIBOR plus 1% from the financial institution. No matter what happens with rates in the future, the floating rate received will equal the floating rate the municipality needs to pay on their debt, this is why it is called a zero basis risk swap. One party could still end up better off, though.

If interest rates rise, this will favor the municipality because they are paying a fixed rate. If interest rates fall, the municipality is worse off than if they didn't use the swap. This is because they will be paying a higher fixed rate, when instead they could have just paid the lower interest rate on their debt directly. While there is the possibility of ending up worse off, municipalities still enter into such agreements since their main goal is to stabilize debt costs, not bet on interest rate movements.

  1. Delayed Rate Setting Swap

    A delayed rate setting swap is an exchange of cash flows, one ...
  2. Liability Swap

    A liability swap is a financial derivative in which two parties ...
  3. Floating Price

    The floating price is a leg of a swap contract that depends on ...
  4. Interest Rate Swap

    An interest rate swap is a forward contract in which one stream ...
  5. Absolute Rate

    The absolute rate is the fixed portion of an interest rate swap, ...
  6. Swap Curve

    A swap curve identifies the relationship between swap rates at ...
Related Articles
  1. Trading

    How To Value Interest Rate Swaps

    An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time.
  2. Trading

    Different Types of Swaps

    Identify and explore the most common types of swap contracts. Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific ...
  3. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  4. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  5. Investing

    CFTC Probes Banks' Use of Interest Rate Swaps

    U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis
  6. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  7. Investing

    PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)

    Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
  8. Investing

    Do Municipal Bond Mutual Funds Offer a Tax Incentive?

    Learn about individual municipal securities and municipal bond funds, whose principal stability and tax-free yield appeal to high-income investors.
  9. Trading

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  10. Investing

    Think Twice Before Buying Tax-Free Municipal Bonds

    Municipal bonds are relatively safe, tax-exempt securities--but they are not without drawbacks. Due diligence is required.
  1. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  2. How do companies benefit from interest rate swaps?

    Learn how companies can swap interest rate payments and mutually benefit. Find out how these swaps arbitrage differences ... Read Answer >>
Trading Center