What Is a Basis Rate Swap? Definition, Example, and Basis Risk

What Is a Basis Rate Swap?

A basis rate swap (or basis swap) is a type of swap agreement in which two parties agree to swap variable interest rates based on different money market reference rates. The goal of a basis rate swap is for a company to limit the interest rate risk it faces as a result of having different lending and borrowing rates.

For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offered Rate (LIBOR), but they borrow money based on the Treasury Bill (T-Bill) rate. This difference between the borrowing and lending rates (the spread) leads to interest rate risk, which refers to the potential that a change in interest rates could lead to investment losses. By entering into a basis rate swap—where the company exchanges the T-Bill rate for the LIBOR rate—the company eliminates this interest rate risk.

Understanding Basis Rate Swaps

Basis rate swaps are a form of interest rate swap involving the exchange of the floating interest rates of two financial assets. These types of swaps allow the exchange of variable interest rate payments that are based on two different interest rates. This type of contract allows a financial institution to turn one floating-rate into another and is generally used for exchanging liquidity.

Usually, basis rate swap cash flows are netted based on the difference between the two rates of the contract. This is unlike typical currency swaps where all cash flows include interest and principal payments.

Basis Risk

Basis rate swaps help to mitigate (hedge) basis risk, which is a type of risk associated with imperfect hedging. This type of risk arises when an investor or institution has a position in a contract or security that has at least one stream of payable cash flows and at least one stream of receivable cash flows, where the factors affecting those cash flows are different than one another, and the correlation between them is less than one.

Basis rate swaps can help reduce the potential gains or losses arising from basis risk, and because this is their primary purpose, are typically used for hedging. But certain entities do use these contracts to express directional views in rates, such as the direction of LIBOR-based spreads, views on consumer credit quality, and even the divergence of the federal funds' effective rate versus the federal funds' target rate.

Example of Basis Rate Swaps

While these types of contracts are customized between two counterparties over-the-counter (OTC), and not exchange traded, four of the more popular basis rate swaps include:

• LIBOR/LIBOR
• Fed funds rate/LIBOR
• Prime rate/LIBOR
• Prime rate/fed funds rate

Payments on these types of swaps will also be customized, but it is prevalent for the payments to occur on a quarterly schedule.

In a LIBOR/LIBOR swap, one counterparty may receive three-month LIBOR and pay six-month LIBOR, while the other counterparty does the opposite. Or, one counterparty may receive one-month USD LIBOR and pay one-month GBP LIBOR, while the other does the opposite.

Special Considerations

One common form of interest rate swap is the plain vanilla swap. This simple swap describes an agreement between two parties where a floating interest rate is exchanged for a fixed rate or vice versa. For each party, there are two legs or components to the vanilla swap: a fixed leg and a floating leg. Both legs of the swap are expressed in the same currency.

For the life of the swap, the notional principal remains the same, and interest payments are netted. A financial institution might engage in a plain vanilla interest rate swap to hedge a floating rate exposure or to benefit from declining rates and move from a fixed to a floating rate.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.