Basis Swap

Basis swap definition

The accepted basis swap definition is the exchange of variable interest rate transactions of two different currencies between two parties in order to hedge against shifts in the interest rates offered by different lending institutions. For instance, within the FOREX market, the London Interbank Offered Rate (LIBOR) and the Federal Reserve often lend at different rates. A company that is constrained to lend at rates tied to the Federal Reserve prime rate but that owes a significant amount of debt tied to the LIBOR rate can find itself in difficulty due to the difference between the two rates and the fluctuations thereof. A basis swap can allow companies to hedge their potential losses by tying the rate that such companies pay for their outstanding loans to the rate they are in turn paid.

Basis swap example

The typical basis swap example involves two companies, one from the U.S. and referred to as Company A, and the other from the United Kingdom and referred to as Company B. Company A owes significant debt tied to the LIBOR rate, but lends its money at a rate tied to the Federal Reserve discount rate. Company B is in the inverse situation wherein it owes debt tied to the Federal Reserve rate, but must lend at a LIBOR-derived rate. By engaging in a basis swap (and perhaps a cross-currency swap) of the loans in question, each company will be able to tie its lending rate directly to the rate at which it can borrow, ensuring a base level of profitability for its lending activities.

Cross-currency basis swaps

Most basis swaps take place on the international FOREX market, and involve a differential between the present values of the two currencies being exchanged; this necessitates the calculation of a basis swap spread. Essentially a basis swap spread is a method of accounting for the difference in value between two currencies; typically, one currency is valued at a flat rate and the spread is added to or subtracted from the value of the other currency, allowing an equitable exchange of debts. Cross-currency basis swaps are a major part of the FOREX market. This has been especially true in recent years with the tightening of money supplies; companies can typically borrow from more liquid economies in the world FOREX market and then return their loans to their native currency through the use of basis swaps, thus obtaining funds they might not otherwise be able to acquire through domestic lenders.
Tim Ord
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