Zero Basis Risk Swap – Definition

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Zero Basis Risk Swap (ZEBRA) Definition

A zero basis risk swap (ZEBRA), also called a ‚Äúperfect swap‚ÄĚ, or ‚Äúactual rate swap‚ÄĚ, 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.

A Little More on What is a Zero Basis Swap Agreement

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 ‚ÄĒ so cash flow is balanced.

References for Zero-Basis Risk Swap

Academic Research on Zero-basis Risk Swap (ZEBRA)

  • ¬∑¬†¬†¬†¬†¬†¬† Swaps: Plain and fanciful, Litzenberger, R. H. (1992). The Journal of Finance,¬†47(3), 831-850. This research work considers the outstanding face amount of plain vanilla interest rate swap that exceeds two trillion dollars as an example in the analyses of this research work. The pricing and hedging of this swap appear to be very simple and a lot of research thesis based their assumptions on the incorrect properties of the swap as a simple exchange of a fixed floating rate note. This research paper provides an option as regards the various assumptions in swaps.
  • ¬∑¬†¬†¬†¬†¬†¬† Measuring basis¬†risk¬†in longevity hedges, Li, J. S. H., & Hardy, M. R. (2011). North American Actuarial Journal,¬†15(2), 177-200. In evaluating the risk associated with index longevity hedges, it is pertinent to never neglect the dependence between the population being hedged and the population underlying the hedging instrument. This paper considered four basic extensions associated with the Lee-Carter model that features such dependence. According to the data obtained from the female population of the United States and Canada, the augmented common factor model was shown as being preferred in the terms of ex-post forecasting performance and goodness-of-fit. This model is used to measure the basic risk associated with the longevity hedge of a 65 years old Canadian.
  • ¬∑¬†¬†¬†¬†¬† Capital constraints, counterparty¬†risk, and deviations from covered interest rate parity, Coffey, N., Hrung, W. B., & Sarkar, A. (2009). According to this research paper, the CIP deviations exist because of the different dollar-denomination interest rate and the exchange rate. Note that the evidence of this deviation is gotten from the interest rate parity (CIP) relation since the beginning of the financial problem in August 2007. Just after the Lehman Brothers went bankrupt, there was an uncertainty about counterparty risk and it became very obvious in the CIP deviations. The result gotten from this paper shows the breakdown of the arbitrage transaction in the international capital market during the crisis among parties.
  • ¬∑¬†¬†¬†¬†¬† Covered interest parity lost: understanding the cross-currency basis, Borio, C. E., McCauley, R. N., McGuire, P., & Sushko, V. (2016). This paper explains the cross-currency basis as a term that explains the covered interest parity loss. This research work suggests a framework that helps economist think about these violations, the stressing of the demand of the combination of hedging and the limits that gives rise to higher arbitrage which reflects stricter management of risk and bank balance sheet constraint.
  • ¬∑¬†¬†¬†¬†¬†¬† Longevity¬†risk, cost of capital and hedging for life insurers under Solvency II, Meyricke, R., & Sherris, M. (2014). Insurance: Mathematics and Economics,¬†55, 147-155. This research paper shows that adopting a reasonable market price of longevity risk, market hedging cost of hedging of the longevity risk as seen in the time past possess higher market hedging cost than the savings in the cost of regulatory capital. The Solvency II was also taken into consideration in this research analyses. The part of the Solvency II capital requirement that is not well understood and that raises germane policy issues for the management of the longevity risk was also carefully explained. The cost of longevity risk management was studied using indemnity based longevity swap compared to the cost of retaining capital under Solvency II.
  • ¬∑¬†¬†¬†¬†¬† The Zeeman Effect in Finance: Libor Spectroscopy and Basis¬†Risk¬†Management, Bianchetti, M. (2011). This paper explains the simple empirical fact that harbours the important consequences coupled with the derivative‚Äôs risk and trading management, for examples like asking the question based on the basis risk and the called CSA discounting. This paper also studies the problem that has prevented the proper research that should have been done on the modern animal farm, the Zeeman‚Äôs effect and recurring to a nice example with quantum physics. The classic financial world studied in quotes and various examples that explain this theory was given and explained in this research thesis.
  • ¬∑¬†¬†¬†¬†¬†¬† The behaviour of emerging market sovereigns’ credit default¬†swap¬†premiums and bond yield spreads, Adler, M., & Song, J. (2010). International Journal of Finance & Economics,¬†15(1), 31-58. According to this research work, a test was carried out to examine whether the credit risk for Emerging Market Sovereigns is priced evenly in the bond and credit default swap market. The prices below par in this paper result in positive outcomes which means that the Credit Default Swap (CDS) premiums are greater than the bond yield spread and vice versa. In other to ascertain adjustment in the price of the non-par, a new bond yield spread that was implied by the term structure of the Credit Default Swap was constructed for various stages of the maturities. The non-parties in this paper were discovered after the main adjustment in countries in Latin America where the bid-ask is lesser compared to the bases in the spread market.
  • ¬∑¬†¬†¬†¬†¬†¬† The CDS bond basis spread in emerging markets: Liquidity and counterparty¬†risk¬†effects (draft), Levy, A. (2009). ¬†This research analysis explores the similarities between the Credit Default Swap (CDS) and the bond spread for emerging the market sovereign entities. Research from previous studies indicates that this similarity is as a result of the interactions between the bonds and the CDS for the United States corporate bonds. To explain the pricing deviations in these bonds, the counterparty risk and liquidity were focused on and studies exclusively. The result gotten from this research explains the importance of these aforementioned factors to the pricing of the Credit Default Swap.
  • ¬∑¬†¬†¬†¬†¬†¬† A multi-quality model of interest rates, Kijima, M., Tanaka, K., & Wong, T. (2009). Quantitative Finance,¬†9(2), 133-145. This paper examined the consistent pricing model of the government bonds, the interest rate swaps and the basis swaps in currency within the no-arbitrage framework. According to this study, a three yield-curve model was proposed, one for the discounting flows, one for calculating the coupon rates of government bond and the last one is used for discounting cash flow. From this three yield-curve model, a quadratic Gaussian model was also proposed as a peculiar model that provided an excellent fit to the current low-interest rate in the Japanese environment.
  • ¬∑¬†¬†¬†¬†¬†¬† The CDS-bond basis arbitrage and the cross-section of corporate bond returns, Li, H., Zhang, W., & Kim, G. H. (2011). SSRN eLibrary. This research paper provides a comprehensive and empirical study on the consequences of the Credit Default Swap bond basis arbitrage for the pricing of corporate bonds. This paper proved that a basis factor proposed as the rerun differential between high and low quintile basis portfolio and termed it as a superior empirical proxy that seizes the new risks. The basis factor in the cross-section of investment grade bond return carries an annual risk premium of about 3% in normal periods. The Basis arbitrage brought new risk such as the counterparty and liquidity risk into the corporate bond market dominated by passive investors before the arrival of the CDS.
  • ¬∑¬†¬†¬†¬†¬†¬† Sovereign CDS and bond pricing dynamics in the euro-area, Palladini, G., & Portes, R. (2011).¬† No. w17586). National Bureau of Economic Research. This paper tests the price discovery in the relationship between bond yield spread and the sovereign Credit Default Swap on the reference entity. The first step adopted in this research work is the verification of supposed non-stationary of the two series. After this verification, we test whether the non-stationary Credit Default Swap (CDS) and the bond spread series are joined by a co-integration relationship. However, the theoretical value of the co-integration vector was annulled which indicates that the synthetic market valuation, the cash and the short run of nth credit risk are greatly different from the various degrees. After hypothesis was made, there were confirmed using the Granger Causality Test which helps is an important forecasting tool that helps to predict the bond yield spread.

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