Cross currency basics 4 – Uses for buy-side and complex pricing
This is the fourth instalment of my series in cross-currency swaps. Previous articles have covered the basics, looked at some pricing aspects and the revaluation challenges brought about by changing conventions. This time I move to some of the uses for cross-currency swaps and how the trades are structured and priced.
Many buy-side participants in the market are looking to hedge real risks and/or move exposures or capital from one currency to another. The final price is often built from several markets and the outcome may be confusing or opaque. The inputs can use different reference rates such as SOFR or LIBOR, have 3, 6 or 12-month floating refixes and settlements and many other variants.
All this can be complex to price and understand when looking at a transaction.
This blog looks at some examples of commonly used cross currency-swaps and how some of the inputs to the pricing are used to build a final product.
Fixed to floating cross-currency
A very common trade is related to debt instrument issued in one currency with the proceeds to be used in another currency. An example is where an Australian issuer taps the USD debt markets with a fixed rate debt issue and wishes to use the proceeds for activities in AUD. The size of Australia’s considerable capital flows makes this trade a vital component of the financial system.
Another example is a French issuer also tapping the USD debt markets and swapping the proceeds back to EUR.
The outcomes are quite interesting and offer some insights to the pricing.
5-year USD fixed rate debt issue by Australian firm looking for AUD BBSW
In this example, the inputs and pricing approach is as follows:
Fixed rate debt is issued with yield 3.00% semi fixed coupons
USD IRS (semi 30/360 against 3-month LIBOR) with yield 2.00%
Calculate the LIBOR spread, SL = 300 – 200 = 100 bps
USD LIBOR to 3-month SOFR with spread 23 bps
Calculate the SOFR spread, SF = 100 + 23 = 123 bps
USD SOFR to AUD BBSW 3-month with spread 9.625 bps
Calculate the AUD BBSW spread, SA = 132.625 bps
As we can see, the number of pricing inputs and calculations is substantial, but the simple math works out ok.
However, this calculation ignores any convexity impacts. The correct price is actually SA = 133.625 bps which is 1 basis point higher because AUD interest rates are higher than USD interest rates and the convexity effect increases the spread.
Of course, points 2 -5 can be changed if the SOFR IRS is used instead of the LIBOR IRS. But remember that the SOFR OIS is typically quoted with annual fixed coupons which will also have to be adjusted to semi-annual 30/360 for the pricing to calculate SF.
5-year USD fixed rate debt issue by French firm looking for EUR Euribor
This example is quite similar to the AUD version except an additional basis market (€STR versus Euribor) is included:
Fixed rate debt is issued with yield 3.00% semi fixed coupons
USD IRS (semi 30/360 against 3-month LIBOR) with yield 2.00%
Calculate the LIBOR spread, SL = 300 – 200 = 100 bps
USD LIBOR to 3-month SOFR with spread 23 bps
Calculate the SOFR spread, SF = 100 + 23 = 123 bps
USD SOFR to EUR €STR with spread -20 bps
Calculate the EUR €STR spread S€ = 103 bps
EU €STR to Euribor with spread 16.20 bps
Calculate the EUR Euribor spread SE = 86.80 bps
As we can see, the number of pricing inputs and calculations have increased but the simple math still works out ok. Note also that we had to add points 8 and 9 because the USD/EUR cross-currency is quoted as SOFR/€STR and we are looking for the relevant spread to Euribor.
This calculation again ignores any convexity impacts. The correct price is actually SE = 78.10 bps which is 7.7 basis points lower because EUR interest rates are lower than USD interest rates and the convexity effect reduces the spread.
Implications for buy-side users
The number and complexity of the pricing inputs coupled with convexity impacts can make the whole process quite cumbersome and complex.
Market quotation conventions and inputs can vary across currencies and can sometimes be quite challenging to discover. Even small changes to conventions can make significant changes to the price.
As I mentioned in the previous blog, booking and valuation systems are also challenging for many users. The cross-currency trade you book will have to be revalued at some time and the inputs required to reconstruct to price are the same as the original inputs. All of these must be carefully defined in systems if you are to avoid valuation disasters.
Summary
I highly recommend all users fully understand the inputs to the pricing and at least perform a ‘back-of-the-envelope’ calculation to get an initial price check similar to the steps above. But nothing replaces a full pricing process which will adjust correctly for all conventions and convexity impacts.
An accurate price at inception is essential and it has to be supported through the life of the transaction for any amendments and valuations in systems and processes.
The possible uses for Term Risk Free Rates (RFRs) and credit-sensitive reference rates such as Ameribor and BSBY will be covered in a future blog. While these reference rates are not widely used at present, there is considerable interest from buy-sude users as they may be a better fit than compounded RFRs for them.
Martialis is actively supporting our clients in pricing generally and cross-currency in particular. We see these issues regularly but they quite solvable with some dedicated assistance.