A basis swap (bs) is a cash settled swap where the fixing basis for the swap's underlying is the price differential between two predefined commodities, i.e., the basis.
In SDX Commodities & Energy, a basis swap is a swap on the price differential between the Henry Hub Natural Gas asset and a selected US or Canadian natural gas asset traded at a different location (or hub). According to market convention, the Henry Hub Natural Gas asset is always used with a selected US or Canadian natural gas asset.
The basis is displayed in the pricing page in the Swap Rate result and is calculated as follows:
Swap price of the hedged asset - the futures price of the Henry Hub Natural Gas exchange traded contract
On the settlement date, if the underlying (i.e., the basis) is higher than the fixed rate, the basis swap buyer receives the difference between the two from the basis swap seller. If the underlying rate is lower, the basis swap buyer pays the basic swap seller the difference.
Natural gas is priced and traded at different locations throughout the country. These locations, which are called hubs, are located at the intersection of major pipeline systems. In the US there are over 30 major market hubs, the principle of which is known as the Henry Hub and is located in Louisiana. The futures contracts traded on NYMEX are Henry Hub contracts, meaning they reflect the price of natural gas for physical delivery at this hub. The price at which natural gas trades differs across the major hubs, depending on the supply and demand for natural gas at that particular point. The difference between the Henry Hub price and the price at another hub is called the location differential. This is the same as the basis.
Why enter into a basis swap?
A basis swap is generally used to hedge or speculate on Basis Risk.
The distinction between what an exchange traded option can hedge and what the user wants to hedge is often the source of basis risk. Accordingly, if you use an exchange-traded futures contract to hedge a position based on a different commodity, you will then need something to manage your basis risk.
There are a number of contracts available in the OTC market to hedge the differences between exchange-traded standard contracts and the hedged instrument, but the simplest is a basis swap. Using a basis swap basically closes the gap between the exchange-traded futures contract's price and the price of the other asset to give you price certainty.
Pricing a basis swap in SDX Commodities & Energy
When defining a basis swap:
The first asset is always Henry Hub Natural Gas (this is according to market convention); however you can select the second asset from a list of the US and Canadian natural gas commodities supported on the system.
You define a volume for the Henry Hub Natural Gas asset. The system automatically applies this volume to the other asset.
For each asset you must define if the weight is - or +.
- means that you selling the asset.
+ means that you are receiving the asset.
You must define if you are buying or selling the basis swap. In theory, if you are buying it, this means you are receiving the natural gas and selling the Henry Hub asset; if you are selling it, you are selling the natural gas and receiving the Henry Hub asset.
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Toggling the Buy <> Sell button affects the weight set for each asset. |
You must define the basis swap term.
The system then uses this to determine the actual swap, which is always a calendar month—as noted by the Begin Date and End Date fields.
As soon as you define the basis swap term, in the Traded Rate field the system displays the fixed rate that will give a zero cost instrument (i.e., it is defined to be the same as the calculated swap rate). You can then manually change the fixed rate and recalculate the instrument. However, if you do change the fixed rate note that this action will affect the present value of the basis swap.