Zero Basis Risk Swap (ZEBRA)
What Is a Zero Basis Risk Swap (ZEBRA)?
A zero basis risk swap (ZEBRA) is a interest rate swap agreement between a region 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 specific swap is viewed as zero-risk in light of the fact that the region receives a floating rate that is equivalent to the floating rate on its debt obligations, intending that there is no basis risk with the trade. The ZEBRA is otherwise called a "wonderful swap" or "genuine rate swap."
Understanding a Zero Basis Risk Swap (ZEBRA)
ZEBRAs involve the region paying a fixed rate of interest on a predetermined principal amount to the financial intermediary. In return, they receive a floating rate of interest from the financial intermediary. The floating rate received is equivalent to the floating rate on the outstanding debt initially issued by the region to the public.
Basis risk is the financial risk that offsetting investments in a hedging strategy won't experience price changes in completely inverse headings from one another. This imperfect correlation between the two investments makes the potential for excess gains or losses in a hedging strategy, subsequently adding risk to the position. A ZEBRA is free from such risk.
Districts utilize these types of swaps to oversee risk, as the swap makes more stable cash flows. Assuming the floating rate on their debt rises, the floating rate they receive from the ZEBRA swap likewise rises. This keeps away from the situation where interest on debt rises however those higher interest charges are not offset by higher interest payments coming in.
The region generally pays the fixed interest rate in a ZEBRA swap. This permits them to keep their cash flows stable; they understand what they will be paying out, and furthermore realize that the floating rate they pay will be similarly offset by the floating rate they receive.
ZEBRA swaps are traded over-the-counter (OTC) and can be for any amount agreed on by the region and the financial institution counterparty.
Illustration of a Zero Basis Risk Swap (ZEBRA)
Say a region has $10 million in floating-rate debt issued at the prime rate plus 1%, with the prime rate at 2%. The region consents to pay a fixed rate of 3.1% to a financial intermediary for a term agreed to by the gatherings. In exchange, the district receives floating interest rate payments of the prime rate plus 1% from the financial institution.
Regardless of what occurs with rates from here on out, the floating rate received will rise to the floating rate the district needs to pay on their debt. Therefore it is called a zero basis risk swap.
However, one party might in any case wind up better off. In the event that interest rates rise, this will lean toward the region since they are paying a fixed rate. On the other hand, ought to interest rates fall, the region is more regrettable off. This is on the grounds that they will be paying a higher fixed rate when rather they might have just paid the lower interest rate on their debt straightforwardly.
While there is the possibility of ending up more terrible off, districts actually go into such agreements since their fundamental goal is to balance out debt costs, not bet on interest rate developments.
- A swap is an over-the-counter (OTC) derivative where one party pays the other party a fixed interest rate and receives a floating rate.
- A zero basis risk swap (ZEBRA) is an interest rate swap went into between a region and a financial intermediary.
- A ZEBRA involves the district paying a fixed rate of interest on a predefined principal amount to the financial intermediary.