Not all interest rate swaps involve a fixed rate. Sometimes, a company or bank needs to exchange one type of floating interest rate for another. This is where a basis swap comes in.

A basis swap is an agreement between two parties to exchange cash flows based on two different floating interest rate benchmarks. Instead of swapping a fixed payment for a variable one, both legs of the transaction are variable, just tied to different indices.

The primary use of a basis swap is to manage a mismatch between assets and liabilities. A financial institution might, for example, issue loans that earn interest based on a 3-month benchmark rate. However, it might fund those loans by taking deposits that pay interest based on a 1-month benchmark.

This creates a problem. The bank's income (from loans) resets every three months, while its expenses (interest on deposits) reset every month. If the 1-month rate rises sharply while the 3-month rate stays flat, the bank's profit margin gets squeezed.

To hedge this, the bank can enter a basis swap. It would agree to pay a counterparty the 3-month rate (which matches its loan income) and receive the 1-month rate (which matches its deposit costs). This swap effectively converts its 3-month asset into a 1-month asset, aligning it with its liabilities.

By using the swap, the bank neutralizes the volatility caused by the two different rates moving independently. Its net cash flow becomes much more predictable.

A basis swap sounds like a perfect hedge, but it isn't. The core risk involved is called basis risk. This is the danger that the spread, or "basis," between the two floating rates will change over time.

In our bank example, the swap works perfectly if the difference between the 3-month SOFR and 1-month SOFR is stable. But what if it's not? Market conditions, liquidity, and investor expectations can cause this spread to widen or narrow unexpectedly. If the bank agrees to receive the 1-month rate plus a fixed spread of, say, 0.10%, but the actual market spread widens to 0.25%, the hedge is no longer perfect. The bank loses out on the difference.

This means the swap doesn't eliminate risk entirely; it transforms it. The bank is no longer exposed to the independent movements of two different rates, but it is now exposed to the movement of the spread between them.

This risk is fundamental. Even when hedging with instruments that seem closely related, small differences in their characteristics can lead to unexpected gains or losses. Managing a basis swap hedge requires constantly monitoring the relationship between the two underlying benchmarks.