When an investor trades in two different floating financial instruments with two different rates or maturities, he or she faces a risk from the price fluctuations of the two financial instruments. The price fluctuations could create profits, but they also could cause losses. A basis swap takes the uncertainty out of the situation. The investor signs a basis swap contract with another party to exchange a cash flow in one floating rate for a cash flow in another floating rate so he or she only needs to deal with one floating rate. Financial entities carry out basis swaps in the over-the-counter (OTC) market, without the help of a formal exchange institution.
There are two types of basis swaps. Simple basis swap only involves one currency, while a cross-currency basis swap involves two currencies. Simple basis swaps are more common, but both swaps have similar concepts.
Government agencies and financial institutions conduct a basis swap when they borrow and lend funds in different interest rates. For example, a bank pays its lenders at the London Interbank Offer (LIBOR) rate and gets loan payments at the prime rate. A basis swap removes the difference between the bank's income and expense, eliminating the risk of losses from interest rates changes.
A simple basis swap can involve the same floating rate with different maturities. For example, Investor A receives payments based on the three-month LIBOR rate but makes payments at the six-month LIBOR rate. To match his cash flows, he signs a contract to give his incoming cash flows — the ones based on the three-month LIBOR rate — to Party B in exchange for receiving cash flows based on the six-month LIBOR rate. In such a contract, Investor A would pay Party B every three months, while Party B would pay Investor A every six months. Otherwise, the two parties could pay on the same dates, with Investor A accumulating two payments and paying every six months.
Another kind of basis swap is one that involves two currencies. Multinational financial entities that handle more than one currency usually use currency swaps to eliminate the risk of currency fluctuations. They use cross-currency basis swaps to ensure adequate supply of a liquid currency. The company would sign a basis swap contract to exchange a liquid currency for a less liquid currency.
Basis swaps are most common in the U.S., where a few floating indexes are used. Standard U.S. floating indexes include commercial paper (CP), LIBOR, prime and T-bill. Other countries have fewer floating indexes and conduct fewer basis swaps.