What Is a Zero Basis Risk Swap (ZEBRA)?
An interest rate swap arrangement between a financial intermediary and a municipality is a zero-basis-risk swap (ZEBRA). An exchange is a two-party arrangement in which one party obtains a variable interest rate and pays the other party a fixed interest rate.
Since no basis risk is associated with the deal and the municipality obtains a floating rate equal to the floating rate on its debt obligations, this specific swap is regarded as zero risk. Other names for the ZEBRA include “perfect swap” and “actual rate swap.”
A Comprehensive Guide on Zero Basis Risk Swaps (ZEBRA)
Under ZEBRAs, the municipality gives the financial intermediary a set interest rate on a predetermined principal amount. The financial intermediary offers them a variable interest rate in exchange. The floating rate the municipality initially offered to the general public is the same as on the received outstanding debt.
The financial risk that offsets investments in a hedging strategy that won’t see price fluctuations that are entirely at odds with one another is known as basis risk. In a hedging system, this poor connection between the two assets raises the possibility of extra profits or losses, which increases positional risk. There is no such danger for a zebra.
Municipalities use these swaps as a risk management tool since they provide more consistent financial flows. Their floating rate from the ZEBRA swap increases with an increase in the floating rate on their debt. Doing this makes it less likely that loan interest rates will rise without additional outstanding interest payments to offset the increase.
In a ZEBRA exchange, the municipality always pays the agreed-upon interest rate. Because they know exactly what they will be paying out and that the floating rate they get will match the floating rate they pay, this enables them to maintain consistent cash flows.
Zebra swaps may be exchanged over-the-counter (OTC) for any sum the counterparty financial institution and the municipality agree upon.
A Zero Basis Risk Swap (ZEBRA) example
Assume a town has $10 million in floating-rate debt that is repaid at a rate equal to 1% plus the prime rate, now 2%. For a duration decided upon by the parties, the municipality agrees to pay a financial intermediary a set rate of 3.1%. The financial institution provides the city with variable interest payments equal to the prime rate plus 1% in return.
The floating rate received will always be equal to the floating rate the municipality must pay toward its debt, regardless of future rate changes. It is known as a zero-basis risk swap for this reason.
However, one side can still come out ahead in the end. The municipality will benefit from rising interest rates since they pay a fixed rate. If interest rates decline, the city will be in a worse situation. This is because they could have spent the lower interest rate on their loan immediately, but instead, they will be paying a higher fixed rate.
Municipalities participate in such arrangements even though they may end up worse since their primary objective is to stabilize debt expenses rather than place a wager on changes in interest rates.
Conclusion
- An interest rate swap between a municipality and a financial intermediary is a zero-basis-risk swap (ZEBRA).
- An over-the-counter (OTC) derivative, known as a swap, occurs when two parties exchange fixed interest rates in exchange for fluctuating rates.
- Under ZEBRA, the municipality gives the financial intermediary a set interest rate on a predetermined principal amount.
