Zero Basis Risk Swap (ZEBRA)

A zero basis risk swap (ZEBRA) is an interest-rate swap structured so the floating rate a municipality receives exactly matches the floating rate on its outstanding debt. Because the floating receipts and the floating debt payments move one-for-one, the swap eliminates basis risk and is often called a “perfect swap” or “actual rate swap.”

How it works

• The municipality enters into an over-the-counter (OTC) swap with a financial intermediary.
• The municipality pays a fixed interest rate to the intermediary on a specified notional principal.
• The intermediary pays the municipality a floating rate that is identical to the floating rate the municipality owes on its public debt.
• Net cash flows are then the difference between the fixed payment and the floating receipts (or vice versa), depending on payment timing and netting arrangements.

What is basis risk?

Basis risk is the risk that two rates intended to offset each other do not move in perfect correlation, leaving a hedged position exposed to unexpected gains or losses. A ZEBRA removes that risk by tying the swap’s floating leg to the same reference rate the municipality pays on its debt.

Why municipalities use ZEBRAs

• Stabilize debt service cash flows: by paying a known fixed rate, municipalities can budget and plan with greater certainty.
• Eliminate mismatch risk: if the swap’s floating payments track the debt’s floating payments exactly, rising floating rates are offset by higher swap receipts.
• Flexibility: traded OTC and can be sized to match the municipality’s debt amount and term.

Example

A municipality has $10 million of floating-rate debt priced at prime + 1% (prime = 2%). The municipality enters a ZEBRA where it:
– Pays a fixed rate of 3.1% to the financial intermediary.
– Receives floating payments equal to prime + 1% from the intermediary.

If prime rises, the floating receipts from the swap increase by the same amount the municipality’s debt payments increase, preserving stable net cash outflow equal to the fixed rate (ignoring fees and timing differences).

Benefits and drawbacks

Benefits
– Eliminates basis risk between the swap and the underlying debt.
– Provides predictable, stable debt service via a fixed-rate obligation.
– Can be customized OTC to match notional and tenor.

Drawbacks and considerations
– Interest-rate exposure remains: if rates fall, the municipality may pay a fixed rate that is higher than market rates.
– Counterparty/credit risk: as an OTC instrument, performance depends on the financial intermediary’s ability to pay.
– Documentation and legal/credit arrangements (e.g., collateral, termination provisions) matter and can affect outcomes.
– Accounting, regulatory, and disclosure requirements may apply and should be reviewed before entering a swap.

Key takeaways

• A ZEBRA is an OTC interest-rate swap that removes basis risk by matching the swap’s floating leg to the municipality’s floating-rate debt.
• It converts variable-rate obligations into effectively fixed-rate obligations, improving cash-flow predictability.
• The arrangement reduces basis risk but does not eliminate interest-rate risk or counterparty credit risk; careful structuring and counterparty assessment are essential.