Basis swapWikipedia open wikipedia design.
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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.Both legs of a basis swap are floating but derived from different index rates (e.g. LIBOR 1 month vs 3 month). Basis swaps are settled in the form of periodic floating interest rate payments. They are quoted as a spread over the reference index.
Usage of basis swaps for hedging
A basis swap can be used to limit interest rate risk that a firm faces as a result of having different lending and borrowing rates. Basis swaps help investors to mitigate basis risk that is a type of risk associated with imperfect hedging. Firms also utilize basis swaps to hedge the divergence of different rates.
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 is 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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