Interest rate swaps (IRS) are powerful tools to transfer the cash flows of assets and liabilities to fixed from floating and vice versa. They are also used for transferring the cash flow from one tenor to another -- i.e., if we have a cash flow at 3 months and we want to convert this cash flow to monthly one, we can use the basis swap to get this done. The valuation methodology for IRS is very well documented but the value of a basis swapis seldom mentioned. The challenges in valuation of a basis swap arise due the presence of credit/liquidity risk to the party which pays the monthly cash flows and receives quarterly payments.
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