Basis swap
Encyclopedia
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.
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 are 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. Trading in PRDC usually involves using Basis Swaps to hedge against basis risk between JPY LIBOR and EUR LIBOR yields. Hence basis swaps can be used to hedge.
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
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.
Usage of basis swaps for hedging
Basis riskBasis risk
Basis risk in finance is the risk associated with imperfect hedging using futures. It could arise because of the difference between the asset whose price is to be hedged and the asset underlying the derivative, or because of a mismatch between the expiration date of the futures and the actual...
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
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
between those factors are 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. Trading in PRDC usually involves using Basis Swaps to hedge against basis risk between JPY LIBOR and EUR LIBOR yields. Hence basis swaps can be used to hedge.
- 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 curveYield curveIn finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
(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
- Interest rate swapInterest rate swapAn interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
- Basis tradingBasis tradingBasis trading is a trading strategy usually consisting of the purchase of a particular security and the sale of a similar security ....