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What is Zero Basis Risk Swap ?

1054 reads · Last updated: December 5, 2024

A zero basis risk swap (ZEBRA) is an interest rate swap agreement between a municipality and a financial intermediary. A swap is an agreement with two counterparties, where one party pays the other party a fixed interest rate and receives a floating rate.This particular swap is considered zero-risk because the municipality receives a floating rate that is equal to the floating rate on its debt obligations, meaning that there is no basis risk with the trade. The ZEBRA is also known as a "perfect swap" or "actual rate swap."

Definition

A Zero Basis Risk Swap (ZEBRA) is an interest rate swap agreement between a municipal entity and a financial intermediary. In this swap, one party pays a fixed interest rate while the other pays a floating rate. It is considered zero risk because the municipal entity receives a floating rate equal to its debt obligations, eliminating basis risk. This swap is also known as a 'perfect swap' or 'actual rate swap'.

Origin

The Zero Basis Risk Swap originated from the need for municipal debt management, aiming to help municipal entities better manage interest rate risk. As the municipal debt market evolved, this tool was introduced to provide more stable financial planning.

Categories and Features

Zero Basis Risk Swaps are mainly categorized into fixed-to-floating and floating-to-floating swaps. In a fixed-to-floating swap, the municipal entity pays a fixed rate and receives a floating rate. In a floating-to-floating swap, both parties exchange different floating rates. The main feature is the elimination of basis risk, providing interest rate stability.

Case Studies

Case 1: A municipal entity enters into a zero basis risk swap with a bank, paying a 3% fixed rate and receiving a floating rate matching its debt. This helps the entity lock in interest costs and avoid market volatility risks. Case 2: Another municipal entity uses a zero basis risk swap to convert its floating rate debt to a fixed rate, ensuring predictability in future budgeting.

Common Issues

Investors might misunderstand the 'zero risk' aspect of zero basis risk swaps, assuming there is no risk at all. In reality, it only eliminates basis risk; other risks like credit risk still exist. Additionally, changes in market conditions can affect the swap's effectiveness.

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