Basis Swap Page 1 of 2

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 to
another, 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 structured
transactions (see Examples) and therefore many derivative users may be unaware
that as part of the structure purchased, the bank has utilised a Basis Swap. Basis Risk
refers to the risk of having assets or liabilities denominated in a different "basis" than
that of any benchmark.

EXAMPLE

Investor

A French fund manager is prohibited from assuming foreign exchange risk. While AA
rated French floating rate notes are currently yielding FFR LIBOR plus 12, German
paper with the same credit quality and tenor is yielding DEM LIBOR plus 20bp. The
fund manager can purchase the DEM paper and enter into a Cross Currency Basis
Swap paying DEM LIBOR plus 20bp and receiving FFR LIBOR plus 18bp (see Cross
Currency Swap for more information regarding the pricing differential). The fund
manager has used a basis swap to change the basis of the asset from DEM LIBOR to
FFR LIBOR and eliminate foreign currency exposure at the same time.

Corporate

A company uses a wide range of funding mechanisms taking advantage of the most
efficient source of funds at the time. It generally can raise 3yr funding at either
LIBOR plus 20bp or CP plus 5bp. It needs to be able to convert to the same basis in
order to compare the true funding cost of each. If it was to raise funding at CP plus
5bp, it could enter into a Basis Swap, receiving CP plus 5bp and paying LIBOR plus
18bp for three years, thereby saving 2bp per annum. The company can use Basis
Swaps to monitor all the alternative sources of funding and achieve the cheapest net
cost at any time.

Structuring

A fund manager is looking to swap a 5yr DEM 8% Coupon bond into a floating rate
ESP 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 DEM
LIBOR 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 for
the two indices in question (see Implied Forwards). For example, if USD LIBOR is
implied to average 12% over the next 3 yrs and USD Fed Funds 10%, the 3yr

http://www.ciberconta.unizar.es/bolsa/basis.htm 28/5/2011
Basis Swap Page 2 of 2

LIBOR/Fed Funds Basis Swap will be priced at -2%, i.e. parties can receive Fed Funds
for 3yrs and pay LIBOR less 200bp. For Cross Currency Basis Swaps, the issues
confronting traditional Cross Currency Swaps also apply (see the Pricing section
under Cross Currency Swaps)

TARGET MARKET

The Basis Swap family is a wide one and therefore suitable to a wide range of users
as 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

http://www.ciberconta.unizar.es/bolsa/basis.htm 28/5/2011