A base swap is a contract between two parties to exchange cash flows at different variable rates, eliminating the risk of price fluctuations from trading in two different floating financial instruments. There are two types of base swaps, simple and cross, and they are commonly used by financial institutions and government agencies to eliminate the risk of losses from changes in interest rates and currency fluctuations. Basis swaps are most common in the US.
When an investor trades in two different floating financial instruments with two different rates or maturities, he faces a risk from price fluctuations of the two financial instruments. Price fluctuations could lead to profit, but could also cause loss. A base swap removes the uncertainty of the situation. The investor enters into a basic swap contract with another party to exchange a cash flow at one variable rate for a cash flow at another variable rate, so he only needs to deal with one variable rate. Financial institutions carry out basic swaps in the over-the-counter (OTC) market, without the help of a formal exchange institution.
There are two types of base swaps. Simple base exchange only involves one currency, while a cross base exchange involves two currencies. Simple base swaps are more common, but both swaps have similar concepts.
Government agencies and financial institutions engage in a basis exchange when they borrow and lend funds at different interest rates. For example, a bank pays its lenders at the London Interbank Offered Rate (LIBOR) and gets loan payments at the prime rate. A basis exchange eliminates the difference between the bank’s income and expenses, eliminating the risk of losses from changes in interest rates.
A simple basis exchange may involve the same floating rate with different maturities. For example, Investor A receives payments based on three-month LIBOR but makes payments at six-month LIBOR. To match your cash flows, you enter into a contract to deliver your incoming cash flows, which are based on three-month LIBOR, to Party B in exchange for receiving the cash flows based on three-month LIBOR. six months. In such a contract, Investor A would pay Party B every three months, while Party B would pay Investor A every six months. Otherwise, both parties could pay on the same dates, with Investor A accumulating two payments and paying every six months.
Another type of base 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 swaps to ensure an adequate supply of a liquid currency. The company would enter into a basic swap contract to exchange a liquid currency for a less liquid currency.
Basis swaps are most common in the US, where some floating indices are used. Standard US floating indices include commercial paper (CP), LIBOR, prime, and T-bill. Other countries have fewer floating indices and do fewer base swaps.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
