Basis Rate Swaps

A fast developing area in the international swap markets is the basis rate swap. The structure of the basis rate swaps is the same as the straight interest rate swaps, with the exception that floating interest calculated on one basis is exchanged for floating interest calculated on a different basis. The forerunner of this type of swap was the US Dollar Prime Rate LIBOR swap. However, an even larger market has developed for the exchange of 1 month US Dollar LIBOR for 6 month US Dollar LIBOR and more recently US Dollar LIBOR for US Dollar commercial paper at much finer rates than those available on the foreign exchange market.

The availability of the basis rate swaps market provides an excellent method for entities to arbitrage spreads between different floating rate funding sources. More importantly, it provides a discreet and most efficient method for European entities in particular to stimulate the US Commercial Paper funding market without the necessity of meeting the stringent US requirements for a Commercial Paper programme. To illustrate, consider a transaction structured by Bankers Trust which enabled an European bank to obtain effective 30 day commercial paper funding by converting its 6 month US Dollar funding base into 30 day commercial paper via a basis rate swap. The counter-party to the transaction was a second European bank wishing to match its commercial paper funding programme to its LIBOR asset base.

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