What does basis risk in interest rate swaps refer to?

Basis risk in interest rate swaps refers to the risk of mismatched cash flows that can arise due to fluctuations in the interest rates affecting the two different cash flow streams in the swap agreement. In an interest rate swap, one party typically pays a fixed interest rate, while the other pays a floating rate, which is usually benchmarked to a specific index such as LIBOR or SOFR. Because the floating rate can fluctuate based on changes in the underlying interest rate environment, there is a potential for the cash flows to deviate from expectations.

This misalignment can create a situation where the net cash flows resulting from the swap do not perform as intended, potentially impacting the financial strategy of one or both parties involved in the swap. Therefore, basis risk is specifically about the differences in how the two cash flow streams respond to changes in market interest rates, highlighting the inherent uncertainty in managing interest rate exposure.

Other concepts like the risk of interest rates changing, the risk of default, or the risk of regulatory changes are important, but they pertain to different types of risks associated with interest rates or financial agreements rather than the specific mismatch of cash flows that defines basis risk in the context of interest rate swaps.