A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A floating-floating interest rate swap under which the floating rate payments is referenced to different bases.
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 between those factors are less than one. Entering into a Basis Swap may offset the effect of gains or losses resulted 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 cuve (for example, 1 mo USD LIBOR for 6 mo USD LIBOR)
In loan agreements when a debitor start to pay interest, he or she can hedge risk exposure to interest rates to reduce them by certain basis points within two cashflow streams