Zero Basis Risk Swap - Explained
What is a Zero Basis Risk Swap?
Written by J. Mance Gordon
Updated at April 22nd, 2024
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What is a Zero Basis Risk Swap?
A zero basis risk swap (ZEBRA), also called a perfect swap, or actual rate swap, is a swap arrangement between a municipal government and a financial intermediary. Basically, the municipality agrees to receive a floating (variable) interest rate on an identified amount of principal from the intermediary. In exchange, the municipality pays to the financial intermediary a fixed rate of interest. The initial floating interest rate received from the financial intermediary is equal to the fixed interest rate paid by the municipal government. As such, this swap has a zero basis.
How Does a ZEBRA Swap Work?
The municipality enters into this swap agreement to hedge against the risk associated with issuing bonds. The municipality will issue bonds with a floating or variable interest rate. By paying a fixed interest rate to the intermediary in exchange for a floating rate, they are protected against additional costs if the variable rate of interest goes up. If the variable rate goes down, they pay less on their bonds put lose some money on payments made to financial intermediary. This particular swap is considered zero-risk because the municipality receives a floating rate that is equal to the floating rate on their debt obligations. The swap creates stable cash flows for the municipality. These types of swap agreement are bought and sold in over-the-counter transactions (meaning party-to-party transactions, rather than on public exchanges).
Example of a Zero Basis Swap
Assume a municipal government issues bonds for $1 million. The bonds have a floating interest rate that is tied to LIBOR + 2%. Assume LIBOR is 3%. The municipal government then enters into a swap agreement with a financial intermediary. The agreement requires the municipal government to pay a fixed interest rate of 5%. The intermediary pays the municipal government a floating interest rate of LIBOR +2%. If LIBOR rises, the floating rate received will cover the floating rate being paid on the bonds. If LIBOR falls, the city pays less but receives less so cash flow is balanced.