Basis Swap

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Basis Swap</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#basis swap">basis swap</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="130" align="right" id="table5"> <tr> <td width="10" height="10"></td> <td width="120" height="10"> <font size="2"> </font></td> </tr> <tr> <td width="10"> </td> <td width="120"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">A <b><a name="basis swap">basis swap</a></b> is a floating-floating <a href="../articles/interest_rate_swap.htm">interest rate swap</a>. A simple example is a swap of 1-month <a href="../articles/currency_codes.htm">USD</a> <a href="../articles/libor.htm">Libor</a> for 6-month USD Libor. This might be used to customize exposures to specific points on the <a href="../articles/fixed_income_term_structure.htm">yield curve</a>. More common are basis swaps between two floating indexes from different segments of the money market. A bank that lends at prime but finances itself at Libor, would be a natural user of a prime-Libor basis swap. The bank would be using the swap to eliminate <a href="../articles/spread_risk.htm"> basis risk</a>. It is this general application from which basis swaps derive their name.</p> <p class="body">Standard floating indexes used in the United States include</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/bankers_acceptance.htm">bankers acceptance</a> (BA)</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/certificate_of_deposit.htm">CD</a> rates</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/cofi_index.htm">COFI</a></p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/commercial_paper.htm">commercial paper</a> (CP)</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/fed_funds.htm">Fed funds</a></p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/libor.htm">Libor</a></p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">prime</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">T-bill</p> <p class="body">Basis swaps are less common outside the United States where there are fewer floating indexes to swap between. </p> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="left" id="table6"> <tr> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table><p class="body">Indexes may have different payment frequencies, as in a 1-month Libor for 3-month Libor swap. One solution is to have respective sides of the swap make payments according to their own schedules. The 1-month Libor side would make monthly payments and the 3-month Libor side would make quarterly payments. Another alternative is to accumulate the more frequent payments with <a href="../articles/compounding.htm">compound</a> interest. In this case, 1-month Libor payments would be accumulated and paid quarterly to match the quarterly payments of the 3-month Libor side.</p> <p class="body" style="margin-bottom: 24">Basis swaps are quoted as a spread over one of the indexes with the other index paid "flat." Generally, if 3-month Libor is one of the indexes, the spread is added to the other side.</p> <p class="body" style="margin-bottom: 24">There is an active market for basis swaps structured across currencies. These are just floating-floating <a href="../articles/currency_swap.htm">currency swaps</a>. As with any currency swap, cash flows cannot be <a href="../articles/netting.htm">netted</a>, so all cash flows, including <a href="../articles/par_value.htm">principal</a> payments, are exchanged. Cross currency basis swaps are used primarily for swapping <a href="../articles/liquidity.htm"> liquidity</a>. A firm might borrow in a liquid currency and then swap the loan into its less liquid domestic currency.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/spread_risk.htm">basis risk</a> Risk from exposure to uncertain spreads.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/certificate_of_deposit.htm">certificate of deposit</a> </strong>A money market instrument issued by a depository institution as evidence of a time deposit.</p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/commercial_paper.htm">commercial paper</a> Short-term promissory notes issued primarily by corporations.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/currency_swap.htm">currency swap</a> A swap for the exchange of cash flow streams in two different currencies.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">derivative instrument</strong></a><strong style="font-weight: 400"> An instrument that derives value from the value of some commodity, energy, or other financial instrument.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/fixed_income_term_structure.htm">fixed income term structure</a> Refers collectively to a spot curve, forward curve, discount curve, yield curve or any other curve that describes the time value of money.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/floater.htm">floater</a> A fixed income instrument whose coupon fluctuates with some designated reference rate.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/forward_rate_agreement.htm">forward rate agreement</a> A cash-settled forward contract on a short-term loan.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/cap.htm"><strong style="font-weight: 400">interest rate cap</strong></a><strong style="font-weight: 400"> A derivative instrument which is linked to interest rates.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/interest_rate_spreads.htm">interest rate spreads</a> Spreads between interest rates.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_swap.htm">interest rate swap</a> A swap under which both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations. <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/spread_risk.htm">spread risk</a> Risk due to exposure to some spread.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/swap.htm">swap</a> An OTC derivative under which two counterparties exchange two cash flow streams.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/swaption.htm">swaption</a> An option on a swap.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/treasury_bill.htm">Treasury bill</a> US Treasury security with with a maturity of a year or less at the time of issue.</p> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> 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detailed discussion of basis swaps, primarily from a trader's perspective.</p> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap591"> <area target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm" shape="rect" coords="0, 0, 84, 124"> </map> <img border="0" src="../images/book_das_satyajit_(2003)_125.gif" usemap="#FPMap591" width="85" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm"> Swaps/Financial Derivatives</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Satyajit Das</b></td> </tr> 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src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><b><a target="_top" href="http://www.riskarchive.com/link_thread/98-3/00000093.htm">Pricing of a basis swap</a></b> <i>10 Jul 1998</i><br> Technical challenges of pricing basis swaps.</td> </tr> </table> </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table13"> <tr> <td width="100%" bgcolor="#FFFFFF"> <p align="center" style="margin-top: 18"><map name="FPMap365"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap365" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" 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