What Is a Zero Basis Risk Swap (ZEBRA)?
Let me explain what a zero basis risk swap, or ZEBRA, really is. It's an interest rate swap agreement between a municipality and a financial intermediary. In a standard swap, you have two parties where one pays the other a fixed interest rate and gets a floating rate in return.
What makes this one zero-risk is that the municipality receives a floating rate that's exactly equal to the floating rate on its own debt obligations. That means no basis risk in the trade. You might also hear it called a 'perfect swap' or 'actual rate swap.'
Key Takeaways
- A zero basis risk swap (ZEBRA) is an interest rate swap between a municipality and a financial intermediary.
- A swap is an over-the-counter (OTC) derivative where one party pays a fixed interest rate and receives a floating rate.
- In a ZEBRA, the municipality pays a fixed rate on a specified principal to the intermediary.
Understanding a Zero Basis Risk Swap (ZEBRA)
In a ZEBRA, the municipality pays a fixed rate of interest on a set principal amount to the financial intermediary. In exchange, they get a floating rate back from the intermediary. That floating rate is identical to the one on the municipality's outstanding debt that was issued to the public.
Basis risk is the risk that your hedging investments don't move in perfectly opposite directions, leading to potential extra gains or losses. With a ZEBRA, you don't have that risk at all.
Municipalities turn to these swaps to manage their risks and create more stable cash flows. If the floating rate on their debt goes up, the rate they receive from the swap goes up too. This prevents a scenario where debt interest spikes without any offset from incoming payments.
You should know that the municipality always pays the fixed rate in a ZEBRA. This setup keeps their cash flows predictable—they know exactly what they're paying out, and the floating rate they receive matches what they owe on debt.
Remember, ZEBRA swaps are traded over-the-counter (OTC) and can be for any amount that the municipality and the financial institution agree on.
Example of a Zero Basis Risk Swap (ZEBRA)
Consider this example to see how it works. Suppose a municipality has $10 million in floating-rate debt issued at the prime rate plus 1%, and the prime rate is currently 2%. They agree to pay a fixed rate of 3.1% to a financial intermediary for a term both parties settle on. In return, the municipality gets floating interest payments from the institution at the prime rate plus 1%.
No matter how rates change in the future, the floating rate they receive will always match what they need to pay on their debt. That's the zero basis risk part.
That said, one side could still come out ahead. If interest rates rise, it benefits the municipality since they're locked into paying a fixed rate. But if rates fall, the municipality ends up worse off because they're stuck paying that higher fixed rate when they could have just paid the lower rate directly on their debt.
Even with that possibility, municipalities go for these agreements because their primary aim is to stabilize debt costs, not to gamble on interest rate directions.
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