Why Cross-Currency Basis Swaps Are Year-End Focus: QuickTake Q&A
(Bloomberg) -- A surge in U.S. dollar borrowing costs against the euro and the yen in the closing days of 2017 has cast the spotlight on cross-currency basis swaps. The premium paid to borrow the greenback in exchange for the euro for three months surged to a six-year high, with traders offering various reasons: Year-end demand to tidy up accounts for regulatory scrutiny, or preparations for changes in the U.S. tax code that could drive the repatriation of dollars by U.S. companies.
1. What are cross-currency basis swaps?
They are contracts where two sides agree to exchange interest payments in two different currencies. During the life of the contract, floating interest-rate payments are swapped, typically on a quarterly basis. What makes them unique in the world of swaps is that the parties agree to exchange notional principals, or the face amount used to calculate the payments.
2. Why would anyone need them?
Let’s say a European company needs a dollar loan. While the firm may be well-established on the continent, banks in the U.S. may demand a stiffer rate to lend to a relatively little-known entity. Enter the cross-currency basis swap. The European firm borrows in euros and swaps the payment into dollars with another entity that needs funds in the common currency.
3. Who employs them?
Banks are the biggest users, while hedge funds and proprietary trading firms rank second. The favored currencies are the dollar, euro and yen. Most contracts involve the dollar. They typically range from one to 30 years, reflecting the length of the transactions they fund, such as loans.
4. What is the ‘basis’ in cross-currency basis swaps?
Basis is a measure of how closely the exchange rates (forward and spot) reflect the difference in interest rates. According to a theory known as covered interest parity, a forward exchange rate is priced to take account of the interest received on the currencies over the term of the forward rate, so that an investor will receive at the end the same amount he or she started with; hence the “parity.”
5. Does the theory work?
Not so often. And when it doesn’t, that’s where the "basis" comes in. An example: if the dollar-yen forward exchange rate is 1.59 percent below the spot rate, and the gap between U.S. and Japanese interest rates is 1.23 percentage points, the difference is minus 36 basis points. So, the basis is negative 36. More formally, the basis is the difference between the forward exchange rate and the spot rate minus the difference between the two interest rates.
6. How does a basis swap work?
The basis is used to calculate interest paid during the swap. Say investor A borrows dollars from investor B and simultaneously lends yen, at the spot rate, to investor B. At the end of the swap, the currencies will be returned using the same exchange rate. During the term of the swap, investor A will pay the going interest rate on the dollar and will receive interest on the yen adjusted for the basis.
7. What does a negative or positive basis show?
A negative basis means the investor will receive less interest. It represents the premium the investor must pay over the interest-rate differential. A positive basis means the investor is receiving a discount to the interest-rate differential.
8. What does this mean for companies?
A higher negative basis value means local investors have to bear higher costs to hedge currency risks when buying foreign assets. Companies borrowing locally and converting the proceeds into dollars using basis swaps suffer. A higher negative basis also means dollar holders can take advantage of strong demand for the greenback to enhance returns. It’s a ploy that the Reserve Bank of Australia used when it swapped the bulk of its foreign-currency holdings into yen.
9. How do the two methods come to produce similar results?
Take this example. A Japanese investor bought $1 million at a spot rate of 110.40 on June 2 and agreed to sell three months later with a forward rate of 109.96. The effective borrowing rate works out as 1.59 percent per annum. Using basis swaps instead to lend 110.40 million yen and borrow $1 million, the borrowing rate comes to 1.5575 percent. (That includes 1.22250 percent interest on the dollar loan, based on the London interbank offered rate. The three-month dollar-yen basis swap was quoted at minus 32.25, while the three-month yen Libor was minus 0.01250 percent. Add them together and the interest is minus 0.3350 percent. So this investor has to pay, instead of receive, 0.3350 percent on the yen that was lent, as well as the 1.22250 percent on the dollar loan: a combined 1.5575 percent.)
The Reference Shelf
- A Bank for International Settlements paper explains the cross-currency basis.
- A QuickTake explainer on the U.S. tax proposals to lure companies and cash home.
- Calculate forwards on the Bloomberg terminal with FRD and view cross-currency basis swaps spreads using XCCY.
- Reserve Bank of Australia Deputy Governor Guy Debelle explains how he came to “love the basis.”
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