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Zero Basis Risk Swap (ZEBRA)

Candlefocus Editor
A zero basis risk swap, commonly referred to as a ZEBRA, is a type of interest rate swap traditionally used by municipalities to manage their long-term exposures to and from borrowing costs. A ZEBRA is a particular type of over-the-counter derivative in which a municipality pays the fixed rate of interest to a financial intermediary in exchange for receiving a floating rate of interest. In essence, a municipality will enter into this type of swap in order to fix its borrowing costs over a specified period of time, reducing uncertainty in its expenses and helping it to achieve a more stable financial situation.

A ZEBRA consists of two parties, the municipality and the financial intermediary. The municipality pays the fixed rate of interest on a specified principal amount to the financial intermediary over the specified period of time. The financial intermediary, in turn, pays a floating rate of interest to the municipality, which is determined by the market rate and typically contains a margin that the financial intermediary can benefit from. This type of swap is characterized by the presence of no basis risk, meaning that the risk that the principal amount will not be repaid by the municipality is eliminated.

The advantages of engaging in a ZEBRA are plentiful. Municipalities reap the benefits of having their borrowing costs fixed over the specified period of time, making them more certain of their expenses and allowing them to make better financial plans overall. Moreover, this type of swap can be tailored to represent the exact positions of the municipalities, with fixed payments that best fulfill their requirements and objectives.

At the same time, financial intermediaries are able to benefit from highly attractive margins and from managing the risk on behalf of the municipalities. Furthermore, a ZEBRA can be structured to benefit both parties.

In conclusion, a ZEBRA is an interest rate swap for municipalities to reduce uncertainty in their expenses and have more stability in their financial situation. While the municipality has the advantage of fixed borrowing costs, financial intermediaries benefit from managing the risk on behalf of the municipality. All in all, this type of swap can be tailored to best suit both parties’ requirements and objectives.

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