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BASIS SWAP
DESCRIPTION
An Interest Rate Swap or Cross Currency Swap where both legs are
floating rate.These transactions are used to change the floating
rate "basis" from one index toanother, e.g. 3 month USD LIBOR to 6
month USD LIBOR or 3 month FFR LIBOR to 3
month DEM LIBOR. The floating indices used in these swaps range
from LIBORs of different tenors or different currencies to other
floating indices such as US Prime, CP,Fed Funds etc. Basis Swaps
are an integral building block of many structuredtransactions (see
Examples) and therefore many derivative users may be unawarethat as
part of the structure purchased, the bank has utilised a Basis
Swap. Basis Riskrefers to the risk of having assets or liabilities
denominated in a different "basis" thanthat of any benchmark.
EXAMPLE
Investor
A French fund manager is prohibited from assuming foreign
exchange risk. While AArated French floating rate notes are
currently yielding FFR LIBOR plus 12, Germanpaper with the same
credit quality and tenor is yielding DEM LIBOR plus 20bp. Thefund
manager can purchase the DEM paper and enter into a Cross Currency
BasisSwap paying DEM LIBOR plus 20bp and receiving FFR LIBOR plus
18bp (see CrossCurrency Swap for more information regarding the
pricing differential). The fundmanager has used a basis swap to
change the basis of the asset from DEM LIBOR toFFR LIBOR and
eliminate foreign currency exposure at the same time.
Corporate
A company uses a wide range of funding mechanisms taking
advantage of the mostefficient source of funds at the time. It
generally can raise 3yr funding at eitherLIBOR plus 20bp or CP plus
5bp. It needs to be able to convert to the same basis inorder to
compare the true funding cost of each. If it was to raise funding
at CP plus5bp, it could enter into a Basis Swap, receiving CP plus
5bp and paying LIBOR plus18bp for three years, thereby saving 2bp
per annum. The company can use BasisSwaps to monitor all the
alternative sources of funding and achieve the cheapest netcost at
any time.
Structuring
A fund manager is looking to swap a 5yr DEM 8% Coupon bond into
a floating rateESP note. While this can be done via one
transaction, technically the transaction has
two parts:
(a) Swapping from Fixed DEM to Floating DEM via an Interest Rate
Swap,(pay DEM 8% and receive DEM LIBOR) and(b) Swapping from
Floating DEM to Floating ESP via a Basis Swap (pay DEMLIBOR and
receive ESP LIBOR)
Of course in this instance the receive DEM LIBOR leg of swap 1
and pay DEM LIBOR of swap 2 cancel out.
PRICING
Basis Swap pricing is dependant primarily on the relative
implied forward yields forthe two indices in question (see Implied
Forwards). For example, if USD LIBOR isimplied to average 12% over
the next 3 yrs and USD Fed Funds 10%, the 3yr
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LIBOR/Fed Funds Basis Swap will be priced at -2%, i.e. parties
can receive Fed Fundsfor 3yrs and pay LIBOR less 200bp. For Cross
Currency Basis Swaps, the issuesconfronting traditional Cross
Currency Swaps also apply (see the Pricing sectionunder Cross
Currency Swaps)
TARGET MARKET
The Basis Swap family is a wide one and therefore suitable to a
wide range of usersas valuable tool in converting floating rate
exposure from one basis to another.
ADVANTAGES
Customised
No premiums
Off balance sheet
DISADVANTAGES
Requires ISDA documentation
PRODUCT SUITABILITY
Simple Defensive/Simple Aggressive
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