Basis Swap
A basis swap is a type of derivative contract in which two parties agree to exchange the floating interest rate payments based on two different benchmarks or indices. The benchmarks used in a basis swap could be different currencies, different maturities, or even different types of floating rates.
In a basis swap, one party agrees to pay a fixed or floating interest rate based on one benchmark, while the other party agrees to pay a fixed or floating rate based on a different benchmark. The notional principal amount is exchanged at the beginning and end of the swap agreement, but no principal is exchanged during the life of the swap.
Basis swaps are often used by financial institutions to manage the risk of the basis spread between two different benchmarks. The basis spread refers to the difference between two similar financial instruments with different benchmarks. For example, the basis spread between two government bonds with different maturities or between two different currencies.
One example of a basis swap is a swap between US Treasury bills and LIBOR. In this case, one party agrees to pay the floating rate on US Treasury bills, while the other party agrees to pay the floating rate on LIBOR. The parties agree on the notional amount, the duration of the swap, and the payment frequency.
Basis swaps can be either fixed-for-floating or floating-for-floating. In a fixed-for-floating basis swap, one party pays a fixed rate while receiving a floating rate. In a floating-for-floating basis swap, both parties exchange floating rates based on different benchmarks.
Basis swaps can also be used to take advantage of market inefficiencies or to arbitrage between different markets. For example, if the basis spread between two similar securities is wider than usual, a trader could enter into a basis swap to take advantage of the spread difference.
Overall, basis swaps are a useful financial instrument for managing and hedging risk associated with different benchmarks or market inefficiencies.