A basis swap is an
interest rate swap
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...
which involves the exchange of two floating rate
financial instrument
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
s. A basis swap functions as a floating-floating interest rate swap under which the floating rate payments are referenced to different bases.
The existence of a basis arises from demand and supply imbalances and where, for example, a basis is due for a borrower seeking dollars, this is indicative of a synthetic dollar interest rate in the FX market pricing higher than the direct dollar interest rate. The existence of the basis is a violation of the covered interest rate parity (CIP) condition.
Usage of basis swaps for hedging
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
In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistic ...
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).
See also
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Interest rate swap
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...
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Basis trading
References
Swaps (finance)
Derivatives (finance)
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