{ "id": "8d1fef52-65f7-530e-83ae-8d33edbe1983", "slug": "basis-swap", "term": "Basis Swap", "aliases": [], "category": "Derivatives & Options", "category_slug": "derivatives-options", "difficulty": "intermediate", "definition": "A basis swap is an interest rate swap in which both legs pay floating rates referenced to different benchmark indices — such as 3-month LIBOR versus 6-month LIBOR, or SOFR versus EURIBOR — with neither leg being a fixed rate. The spread between the two floating rates exchanged is the 'basis' and reflects liquidity premiums, credit risk differentials, and supply/demand imbalances between the two reference rates.", "key_takeaways": [ "Unlike a standard (fixed-for-floating) interest rate swap, a basis swap exchanges one floating rate index for another, such as swapping SOFR-based payments for EURIBOR-based payments in cross-currency basis swaps.", "The basis spread — the number of basis points added to one of the floating legs to make the swap fair value — reflects market perceptions of relative funding costs and credit risk between the two indices.", "Cross-currency basis swaps allow multinationals and banks to convert liabilities or assets from one currency into another on a fully hedged basis, accessing the cheapest available funding source globally.", "Widening basis spreads (e.g., 3M LIBOR vs. 1M LIBOR basis) signal increased stress in the interbank funding market and serve as an early warning of credit conditions.", "The TED spread (3M LIBOR minus 3M T-bill yield) is conceptually a type of basis — specifically the credit and liquidity premium embedded in short-term bank borrowing over risk-free rates." ], "detailed_explanation": "The most widely traded basis swaps in the pre-LIBOR transition era were tenor basis swaps (exchanging 3-month LIBOR flat for 6-month LIBOR minus a spread) and cross-currency basis swaps (exchanging USD LIBOR for EUR EURIBOR ± a spread). Post-IBOR transition, the market has evolved toward overnight index swap (OIS) basis swaps — exchanging SOFR flat for EURIBOR, or SOFR for SONIA, or term SOFR for overnight SOFR — with the basis reflecting the compounding convention, currency, and credit risk differences between the indices.\n\nCross-currency basis swaps are particularly important for global banks and corporations. A Japanese bank that wants to raise USD funding can issue yen-denominated bonds (at low domestic rates) and simultaneously enter a USD/JPY cross-currency basis swap to convert those yen obligations into USD cash flows. The economics depend on the cross-currency basis: if the USD/JPY basis is −30bps (meaning the yen payer receives USD SOFR minus 30bps), the effective USD funding cost is SOFR−30bps from the Japanese bank's perspective — potentially cheaper than direct USD issuance. This arbitrage mechanism is why cross-currency basis spreads tend to be mean-reverting over longer horizons.\n\nHistorically, cross-currency basis spreads widened dramatically during financial stress. At the peak of the 2008 financial crisis, the EUR/USD cross-currency basis reached −140bps, reflecting severe USD funding stress among European banks. The spread widened again in 2011–2012 during the European sovereign debt crisis and in March 2020 at the onset of the COVID-19 market dislocation, before Federal Reserve swap lines with foreign central banks compressed the spread back toward zero. Monitoring cross-currency basis is therefore a useful signal of global dollar funding conditions — a key indicator for macro and relative value hedge funds.\n\nIn the post-LIBOR world, basis swaps now trade between different overnight risk-free rates (RFRs). The SOFR/Fed Funds basis swap, for example, reflects the premium or discount between secured (SOFR, backed by Treasury repo collateral) and unsecured (Fed Funds) overnight rates. Under normal conditions this spread is small (2–5bps) but can widen significantly during quarter-end or year-end funding pressures when balance sheet constraints tighten.", "example": "A European bank has raised €1 billion in EUR-denominated bonds at EURIBOR + 80bps and wants to deploy that capital into USD-denominated loan assets earning SOFR + 150bps. To eliminate currency risk, the bank enters a 5-year EUR/USD cross-currency basis swap: it pays EURIBOR flat and receives USD SOFR −20bps (reflecting the current cross-currency basis of −20bps on this tenor). Net USD funding cost: EURIBOR + 80bps (bond) + EURIBOR-paying leg (swap cost) net = SOFR − 20bps (received) + 80bps spread = SOFR + 60bps. Versus USD loan yield of SOFR + 150bps, the bank earns a net margin of 90bps on the USD asset after all hedging costs — the economics of the trade entirely depend on whether the −20bps basis is attractive relative to the bank's alternative cost of direct USD funding.", "formula": "Net Funding Cost (Cross-Currency Basis Swap) = Domestic Bond Coupon + Cross-Currency Basis Spread\nFor a USD receiver: Effective USD Rate = SOFR + Basis Spread", "formula_latex": null, "interactive_type": null, "calculator_id": null, "related_terms": [ "arbitrage", "balance-sheet", "basis", "bond", "cash-settlement", "cost-of-carry", "credit-risk", "delivery-notice", "financial-crisis", "hedging", "interest-rate", "interest-rate-swap", "libor", "liquidity", "margin" ], "backlinks": [ "counterparty-risk", "credit-support-annex", "interest-rate-parity", "isda-agreement", "last-notice-day", "netting", "trade-repository" ], "cross_references": [ "arbitrage", "balance-sheet", "basis", "bond", "credit-risk", "financial-crisis", "hedging", "interest-rate", "interest-rate-swap", "libor", "liquidity", "margin", "premium", "relative-value", "repo", "swap", "yield" ], "tags": [ "level:intermediate", "cat:derivatives-options" ], "asset_classes": [ "derivatives" ], "regulators": [], "see_also": [], "sources": [], "wordcount": 721, "checksum": "a518abb2020dae14", "version": "2026.05.03", "license": "CC-BY-4.0", "updated_at": "2026-09-07T02:15:24+00:00", "_links": { "self": "https://hedgefund.wiki/api/v1/terms/basis-swap", "jsonld": "https://hedgefund.wiki/api/v1/terms/basis-swap?format=jsonld", "markdown": "https://hedgefund.wiki/api/v1/terms/basis-swap?format=md", "graph": "https://hedgefund.wiki/api/v1/graph/basis-swap", "category": "https://hedgefund.wiki/api/v1/categories/derivatives-options", "schema": "https://hedgefund.wiki/schema/term.schema.json", "html": "https://hedgefund.wiki/#/terms/basis-swap" } }