What is a defining feature of basis swaps?

What is a defining feature of basis swaps?

• A. Payments are fixed and do not vary
• B. Payments are based on a fixed interest rate
• C. Each payment stream is tied to a floating rate index
• D. They only involve currency exchange

Answer: (C)

Basis swaps are characterized by the exchange of interest payment streams that are both derived from different floating interest rate indices. This means that in a basis swap, each party pays interest calculated on a varying basis, typically linked to different benchmarks such as LIBOR or EURIBOR. As a result, the payments fluctuate based on changes in these underlying floating rate indices. This feature allows parties to hedge against interest rate risk or to speculate on changes in the spread between the different interest rates. The flexibility offered by the association with floating rates is crucial to the mechanism of basis swaps, distinguishing them from fixed rate or currency swaps. In contrast, options like having fixed payments or payments based on a fixed interest rate indicate a different structure altogether, such as fixed rate swaps, which lack the variable payment characteristic that defines basis swaps. Similarly, the suggestion that basis swaps only involve currency exchange would misrepresent their true nature, as basis swaps specifically pertain to interest rate payments rather than currency fluctuations.

Basis swaps are characterized by the exchange of interest payment streams that are both derived from different floating interest rate indices. This means that in a basis swap, each party pays interest calculated on a varying basis, typically linked to different benchmarks such as LIBOR or EURIBOR. As a result, the payments fluctuate based on changes in these underlying floating rate indices.

This feature allows parties to hedge against interest rate risk or to speculate on changes in the spread between the different interest rates. The flexibility offered by the association with floating rates is crucial to the mechanism of basis swaps, distinguishing them from fixed rate or currency swaps.

In contrast, options like having fixed payments or payments based on a fixed interest rate indicate a different structure altogether, such as fixed rate swaps, which lack the variable payment characteristic that defines basis swaps. Similarly, the suggestion that basis swaps only involve currency exchange would misrepresent their true nature, as basis swaps specifically pertain to interest rate payments rather than currency fluctuations.