Cross currency basics 6 – Revaluation of trades
In this sixth instalment of my series on cross-currency swaps I look at how the changes to market inputs for cross-currency swaps have impacted revaluations since December 2021. Previously, I have looked at pricing of cross-currency trades and this blog extends those concepts to revaluation.
Many of our clients and contacts have fixed USD legs on their cross-currency swaps and as a result, they were not required to make extensive changes to derivative contracts to accommodate the cessation of LIBOR since these deals do not directly reference USD LIBOR. While this is quite correct for the contractual matters, many are now finding the revaluation of these derivatives is no longer accurate.
How could this happen? The trade is fixed USD so there should be no problem with revaluations. However there is a problem, and it needs to be addressed.
Let’s look at the causes and possible solutions.
Possible cause - system revaluation inputs
All booking and revaluation systems require inputs to build the necessary curves and valuation rates for cross-currency swaps. These inputs are very precisely defined and include:
single currency interest rate curves which have a particular day count and frequency on the fixed leg (e.g., 30/360 semi, act/365 quarterly);
cross-currency basis curves (e.g., USD LIBOR/AUD BBSW, USD LIBOR/EURIBOR); and
spot FX rates (e.g., AUD/USD, EUR/USD).
The cause of the revaluation issue is often due to the details of the inputs having changed in the data sources while the revaluation system is still using the current definitions. This causes a significant mismatch, and, in many cases, the mismatch will create havoc in the revaluations!
Some current examples of changes to inputs
As markets transition from LIBOR to other rates, the published curves will change. In some cases, the data source (e.g., Bloomberg) will attempt to derive a synthetic version of the LIBOR rates for continuity, but this is not always the case. And even if the derived LIBORs are available now, there is no guarantee they will always be available.
I have taken a few examples in the following table for a five-year maturity swap with some typical rate inputs.
As you can see, the old and new rates are very different.
Why does this matter?
The changes can be problematic if the data sources used by your revaluation system are collecting the new rates and applying them to the existing input definitions. For example, if your system is configured for USD with LIBOR (old input) and you are now collecting SOFR (new input), the revaluation rate could be 28 basis points different.
Similarly, the AUD/USD cross-currency basis could be 26 basis points different if you are using the current, published basis curves but applying them to the existing definitions in the system.
This mismatch can and does cause many of the current revaluation differences for our clients.
The possible solutions
We recommend the following solutions to this problem:
change the system configuration to the new inputs (preferred); or
modify the new data inputs to create derived inputs for your system (less preferred).
Solution 1 - change the system configuration
Where possible, the neatest and most reliable solution is to ‘raise the hood’ on the revaluation system and start to adjust the settings. This may be as simple as setting up new curves with the new input definitions and allowing the system to sort out the details. But it can also be problematic and challenging without vendor assistance.
While this looks attractive, many systems were not designed for this activity and could require considerable adjustment to assemble the required basis curves (e.g., USD LIBOR/SOFR) to transform the new rate inputs to the required rates for all the currencies.
In the USD case, the fixed rate may be valued from LIBOR-based curves now but SOFR-based when you make the changes. This could amount to 28 basis points which will create a USD value. The cross-currency basis will adjust for this change, but the revaluation offset to the USD difference is on the non-USD side because the cross-currency spread is adjusted on that side.
These changes can have quite significant revaluation impacts and care is required to set up all the new curves and ensure the appropriate basis curves (e.g., USD LIBOR/SOFR) are correctly used to minimise the disruption. But if it is done correctly, this solution can be quite robust.
Solution 2 - modify the new data to create the derived inputs
While this is not our preferred option it is often the only solution if your system cannot be changed to accommodate the new inputs.
In this case, the new inputs are entered into another system (e.g., spreadsheet) and the required inputs for the revaluation system are calculated and then entered each day as usual.
The key issues with this approach are the construction and maintenance of the spreadsheet. The algorithms will need to be prepared and entered to the spreadsheet, and this needs to be maintained for the inevitable errors during the life of the trades.
This approach is also problematic for new trades attached to the new trading conventions which are moving from LIBOR. You may need 2 sets of curves: one for the legacy trades and one for the new trades.
Summary
This is a real and current concern for many firms. Incorrect revaluations can be very frustrating and problematic for accounting accuracy and possible collateral calculations (if required). Significant errors can arise if the inputs and curve configurations in systems are not exactly aligned. Firms should also consider the possible accounting and regulatory implications of revaluation errors.
There are at least 2 workable solutions, but both require expert attention. Adjusting or changing the revaluation system is preferred but sometime this is not possible, and it can be impractical. In that case, the only real option is to create another system to transform the new inputs into the system-required inputs.
Martialis is actively supporting our clients in pricing generally and in cross-currency. We see these issues regularly, but they are quite solvable with some dedicated assistance.