What is a Basis Swap?
A basis swap is a special type of interest rate swap. In an interest rate swap, two parties agree to exchange interest rate payments. Usually one party pays a fixed interest rate and the other party pays a floating rate that can change over time.
In a basis swap, both parties pay floating interest rates instead of one fixed rate and one floating rate. The floating rates are based on different indexes. Some common indexes used in basis swaps are:
- LIBOR (London Interbank Offered Rate)
- EURIBOR (Euro Interbank Offered Rate)
- Commercial paper rates
- Banker’s acceptance rates
- Government bill rates
How Long Do Basis Swaps Last?
Basis swaps usually last for a period of 1 to 10 years. The two parties agree to exchange their floating rate payments on set dates during this period. For example, they might exchange payments every 3 months for 5 years.
Basis Swaps Using Different Currencies
Sometimes, the two floating rates in a basis swap are based on indexes in different currencies. This is another way to create a basis swap. For instance, one party might pay a rate based on USD LIBOR. The other party pays a rate based on GBP LIBOR. The payments would still be exchanged on the agreed schedule over the length of the swap.
Why Do Companies Use Basis Swaps?
Companies and financial institutions use basis swaps to manage interest rate risk or take advantage of differences in rates. There are a few main reasons they use them:
Hedging Interest Rate Risk
Imagine a company has a loan where they pay a floating interest rate based on LIBOR. But their income is based more on the commercial paper rate. The company is worried that LIBOR will increase a lot compared to the commercial paper rate. This would increase their loan payments but their income may not increase as much.
To hedge this risk, the company could enter a basis swap. They would pay a rate based on the commercial paper rate and receive LIBOR. Now their loan payments and income are both based on similar rates. If LIBOR increases more than the commercial paper rate, the extra amount they receive from the swap offsets the higher payments on their loan. This helps control their interest rate risk.
Taking Advantage of Rate Differences
In some cases, a company may think that the difference between two floating rates will change in a way that benefits them. They can try to profit from this view by entering a basis swap.
For example, say the 1-month LIBOR rate is 0.5% higher than the 3-month LIBOR rate. A company might think this gap will get even bigger. They could enter a swap to pay the 3-month rate and receive the 1-month rate. If the difference between the rates widens like they expect, they will end up receiving more than they pay out. They will profit from the swap.
This kind of speculative use of basis swaps is riskier than using them to hedge. The company could lose money if rates don’t move like they expect.
The Risks of Basis Swaps
Like all financial derivatives, basis swaps involve risks. The main risks are:
Counterparty Risk
In any swap agreement, there is a risk that the other party will not make their payments. This is known as counterparty risk. If one party defaults, the other party still has to make their payments but doesn’t receive the payments they are owed. They can lose a lot of money.
To reduce this risk, many swaps are set up with collateral. The parties have to put up assets as a guarantee. If one side defaults, the other can seize the collateral to make up for the missed payments. Using a central clearinghouse as an intermediary can also lower counterparty risk.
Interest Rate Risk
Basis swaps are usually used to manage interest rate risk. But they don’t remove the risk entirely. There is still a chance that rates will move in a way that causes losses for one of the parties.
A company that is hedging may still end up paying more than they receive if the rates don’t move as expected. And a speculative basis swap that is meant to profit from rate changes can easily lose money if the rates move the wrong way.
Liquidity Risk
Most basis swaps are custom agreements between two parties. They are not traded on exchanges. This makes them less liquid than some other investments. It may be hard to get out of a basis swap before it expires if the company needs to for some reason.
Liquidity risk can be lessened somewhat by using standardized terms. But basis swaps are never going to be as liquid as things like stocks or bonds that trade frequently in the markets.
