BASIS SWAP Meaning and
Definition
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A basis swap is a type of financial derivative that involves the exchange of fixed and variable interest rates on a specified notional amount. This exchange is typically conducted between two parties, such as financial institutions or corporations, seeking to manage their interest rate risk exposure.
In a basis swap, both parties agree to exchange the interest rate cash flows based on different reference rates, usually pertaining to the same currency and maturity. The most commonly used reference rates include LIBOR (London Interbank Offered Rate) and Euribor (Euro Interbank Offered Rate).
The purpose of a basis swap is to hedge against or profit from differences in the spread between two reference rates. This spread is called the basis. By executing a basis swap, one party assumes the fixed rate exposure, while the other party takes on the variable rate exposure. Consequently, the party paying the fixed rate is compensated by the counterparty through receiving the floating rate.
The pricing of a basis swap is determined by considering several factors, including the market supply and demand for fixed and floating rate instruments, credit risk, liquidity, and prevailing interest rates. Basis swaps are commonly used to manage interest rate risk, create yield enhancement strategies, or arbitrage opportunities in the financial markets. However, they are also subject to market fluctuations and counterparty credit risk, making them complex instruments that require careful consideration and risk management.
Etymology of BASIS SWAP
The term "basis swap" is derived from the combination of two words: "basis" and "swap".
- Basis: In finance, "basis" refers to the difference between the price of a cash or spot product (such as a bond or currency) and the price of its corresponding futures contract. It represents the cost of carrying the underlying asset until the delivery date of the futures contract.
- Swap: A "swap" is a derivative contract in which two parties agree to exchange financial instruments, cash flows, or other variables over a specific period. Swaps are commonly used for hedging purposes or to manage risks.
When combined, "basis swap" refers to a financial transaction where two parties agree to exchange the floating interest rates of different currencies, while also settling the difference in the underlying interest rate index. This allows them to manage exposure to interest rate risks and take advantage of different market conditions.
