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From: CCH
Affiliation:
Address:
Date: 10/16/2002
Time: 8:06:05 AM
A basis swap is a floating-floating swap, so a Libor-Libor 6'1' pays 6-month Libor vs. 1-month Libor. Timing is asymmetric. The 6-month Libor is paid semiannually. The 1-month Libor is paid monthly. This means that the party paying monthly takes most of the credit risk. She is paying monthly and is exposed to the counterparty's credit until she receives an offsetting payment at the end of each six months. Credit risk impacts pricing. Therefore, on the surface, we would expect the basis swaps to be quoted ABOVE the Libor fixings. For example, we would expect a 6'1' to be quoted as 6-month plus a positive spread vs. 1-month flat. This line of reasoning fails to recognize that the Libor fixings already reflect credit risk. What is more, they don't reflect the modest credit risk associated with the net payments on a swap. They reflect the more significant credit risk associated with an outright unsecured loan. Let's break the swap into its constituent pieces. Consider a USD 10MM 6-month 6'1' Libor-Libor swap. One leg is party A lending party B USD 10MM for 6 months at 6-month Libor flat. The other leg is NOT party B lending party A USD 10MM for 1 month at 1-month Libor. The second leg is not a 1-month loan. It is actually a 6-month floater linked to 1-month Libor. The 1-month Libor fixing reflects credit risk for 1 month. A six month floater entails 6 months of credit risk. For this reason, the 6-month floater will be priced at 1-month Libor plus a positive spread. Translating this back to our basis swap, it means that either the swap will be quoted as 1-month Libor plus a positive spread vs. 6-month Libor flat or (as in your case) as 1-month Libor flat vs. 6-month Libor plus a negative spread.
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