Zero Basis Risk Swap (ZEBRA)

What Is a Zero Basis Risk Swap (ZEBRA)?

A zero basis risk swap (ZEBRA) is an interest rate swap agreement between a municipality and a financial intermediary. A swap is an agreement with two counterparties, where one party pays the other party a fixed interest rate and receives a floating rate.

This particular swap is considered zero-risk because the municipality receives a floating rate that is equal to the floating rate on its debt obligations, meaning that there is no basis risk with the trade. The ZEBRA is also known as a "perfect swap" or "actual rate swap."

Understanding a Zero Basis Risk Swap (ZEBRA)

ZEBRAs entail the municipality paying a fixed rate of interest on a specified principal amount to the financial intermediary. In return, they receive a floating rate of interest from the financial intermediary. The floating rate received is equal to the floating rate on the outstanding debt initially issued by the municipality to the public.

Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position. A ZEBRA is free from such risk.

Municipalities use these types of swaps to manage risk, as the swap creates more stable cash flows. If the floating rate on their debt rises, the floating rate they receive from the ZEBRA swap also rises. This helps avoid the situation where interest on debt rises but those higher interest charges are not offset by higher interest payments coming in.

The municipality always pays the fixed interest rate in a ZEBRA swap. This is what allows them to keep their cash flows stable; they know what they will be paying out, and also know that the floating rate they pay will be equally offset by the floating rate they receive.

Example of a Zero Basis Risk Swap (ZEBRA)

Say a municipality has $10 million in floating-rate debt issued at the prime rate plus 1%, with the prime rate at 2%. The municipality agrees to pay a fixed rate of 3.1% to a financial intermediary for a term agreed to by the parties. In exchange, the municipality receives floating interest rate payments of the prime rate plus 1% from the financial institution.

No matter what happens with rates in the future, the floating rate received will equal the floating rate the municipality needs to pay on their debt. This is why it is called a zero basis risk swap.

One party could still end up better off, though. If interest rates rise, this will favor the municipality because they are paying a fixed rate. Alternatively, should interest rates fall, the municipality is worse off. This is because they will be paying a higher fixed rate when instead they could have just paid the lower interest rate on their debt directly.

While there is the possibility of ending up worse off, municipalities still enter into such agreements since their main goal is to stabilize debt costs, not bet on interest rate movements.