Cross Currency Swaps
Discussion
I haven't done one of these for a while .. but effectively you are swapping two loans in different currencies (and paying interest in different currencies or frequencies) and this is probably the best way to value them. Example: PV(USD loan) - PV(JPY loan). Note: the first exchange of principal will cancel out so you just need to value the remaining flows in their respective currencies.
I'm talking about basis swaps here as cross currency fixed vs floating swaps can be replicated using a basis swap and a vanilla IRS...
If you PV both legs separately each side PV's to zero (as does a FRN) - intuitively you should be able to see that discounting at LIBOR the final exchange together with the the intermediate cash flows (fixed at LIBOR) equals the first exchange.
Therefore simply PV'ing both sides of the swap isn't enough - else the fair value would be a zero spread on both legs. In the real world cross currency basis swaps are priced so the USD leg is trading at a significant premium to the non USD leg (GBP is typically 20 basis points below USD).
Where does the spread come from? There are a number of factors....
Credit. Countries with low-grade ratings trade with a significant negative spread as interbank rates contain a credit premium (in the same way tenor basis swaps do).
Access to funding. If a foreign entity cannot directly access USD funding then they should be charged a premium for synthetically creating USD funding via a basis swap
Bond market liquidity. Companies are forced to borrow offshore and swap back - this drives the spread higher
Supply and demand. If swaps desk are only seeing on side of the market they will market their prices accordingly.
These days (post credit crunch) interbank lending is frozen so banks are scrambling to raise USD synthetically which has forced the spread higher. Additionally, there has been a lot of new issuance almost a all of which has had at least part of it swapped into different currencies - also driving the spread.
I should have a techincal paper somewhere - PM if you'd like me to email it to you.
If you PV both legs separately each side PV's to zero (as does a FRN) - intuitively you should be able to see that discounting at LIBOR the final exchange together with the the intermediate cash flows (fixed at LIBOR) equals the first exchange.
Therefore simply PV'ing both sides of the swap isn't enough - else the fair value would be a zero spread on both legs. In the real world cross currency basis swaps are priced so the USD leg is trading at a significant premium to the non USD leg (GBP is typically 20 basis points below USD).
Where does the spread come from? There are a number of factors....
Credit. Countries with low-grade ratings trade with a significant negative spread as interbank rates contain a credit premium (in the same way tenor basis swaps do).
Access to funding. If a foreign entity cannot directly access USD funding then they should be charged a premium for synthetically creating USD funding via a basis swap
Bond market liquidity. Companies are forced to borrow offshore and swap back - this drives the spread higher
Supply and demand. If swaps desk are only seeing on side of the market they will market their prices accordingly.
These days (post credit crunch) interbank lending is frozen so banks are scrambling to raise USD synthetically which has forced the spread higher. Additionally, there has been a lot of new issuance almost a all of which has had at least part of it swapped into different currencies - also driving the spread.
I should have a techincal paper somewhere - PM if you'd like me to email it to you.
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