An interest rate basis swap which entails the exchange or locking in of the spread between a bond or note yield and the swap rate with identical maturity. In other words, the swap payments are related to the difference between a given point on two different yield curves. As such, it allows the counterparties to take advantage of the widening or narrowing of the difference between the two curves. That is, the swap differential agreement is especially attractive for investors willing to take a position on the convergence or divergence of two different curves. It follows that investors purchase such a swap on the expectation that yield curves will widen, whereas investors expecting curves to narrow would sell it.
As is usually the case in swap markets, the counterparties are free to define settlement dates, the one point on the two yield curves, and the basis point value to be applied to the swap payments.
For example, consider an investor who expects a narrowing differential between a two-year bond yield and a two-year US dollar swap rate over the next year. The investor may sell a Euro-US dollar swap differential agreement for one year at a basis point value of Euro 20,000 (which is the basis of the swap price calculation). At the time of settlement, the final state of the difference between the two yields determines whether the investor will gain or lose. In this token, if the difference has widened relative to the entry yield, say, by five basis points, then the investor ends up losing 10 X 20,000= Euro 100,000. In case the difference has narrowed with respect to the entry yield, say by seven basis points, the investor turns out to be making 7 X 20,000= Euro 140,000.
The entry yield is usually defined as the difference between the implied forward rates from the two yield curves.
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