Basis swap November 17, 2009 at 4:48 pm
We briefly referred to the basis swap, in which both sides pay a floating rate. A typical basis swap involves one party paying LIBOR and the other paying the T-bill rate. As we learned before, the term basis refers to the spread between two prices, usually the spot and futures prices. Here it is simply the spread between two rates, LIBOR and the T-bill rate. Because LIBOR is always more than the T-bill rate, the two parties negotiate a fixed spread such that the party paying LIBOR actually pays LIBOR minus the spread.2′ LIBOR is the borrowing rate of high-quality London banks, and the T-bill rate is the default-free borrowing rate of the U.S. government. The difference between LIBOR and the T-bill rate is thus a reflection of investors’ perception of the general level of credit risk in the market. Basis swaps are usually employed for speculative purposes by end users who believe the spread between LIBOR and the T-bill rate will change.” A basis swap of this type is, therefore, usually a position taken in anticipation of a change in the relative level of credit risk in the market. As noted, both sides are floating, and typically both sides use 360-day years in their calculation.