A basis swap is a floating-floating interest rate swap. A simple example is a swap of 1-month USD Libor for 6-month USD Libor. This might be used to customize exposures to specific points on the yield curve. More common are basis swaps between two floating indexes from different segments of the money market. A bank that lends at prime but finances itself at Libor would be a natural user of a prime-Libor basis swap. The bank would be using the swap to eliminate basis risk. It is this general application from which basis swaps derive their name.
Standard floating indexes used in the United States include
Basis swaps are less common outside the United States where there are fewer floating indexes to swap between.
Indexes may have different payment frequencies, as in a 1-month Libor for 3-month Libor swap. One solution is to have respective sides of the swap make payments according to their own schedules. The 1-month Libor side would make monthly payments and the 3-month Libor side would make quarterly payments. Another alternative is to accumulate the more frequent payments with compound interest. In this case, 1-month Libor payments would be accumulated and paid quarterly to match the quarterly payments of the 3-month Libor side.
Basis swaps are quoted as a spread over one of the indexes with the other index paid “flat.” Generally, if 3-month Libor is one of the indexes, the spread is added to the other side.
There is an active market for basis swaps structured across currencies. These are just floating-floating currency swaps. As with any currency swap, cash flows cannot be netted, so all cash flows, including principal payments, are exchanged. Cross currency basis swaps are used primarily for swapping liquidity. A firm might borrow in a liquid currency and then swap the loan into its less liquid domestic currency.