A Closer Look at the Cross-Currency Basis

June 17, 2024

Market data comes from a market data provider. Well, usually. Cross-currency basis spreads can be hard to get, but they may be already lurking in your treasury system, waiting to go into the pricing. How come and what’s next? Let’s take a closer look.

The Global Financial Crisis changed the rules of the financial markets. The covered interest parity (CIP), the closest thing to a law in international finances, does not seem to hold anymore. CIP defined the relationship between interest rates and the spot and forward currency rates of two countries. It postulated that the difference in interest rates should equal the forward and spot exchange rates. Introduced in 1923 in no-arbitrage conditions, CIP provided the basis for pricing for many years.

Since the Global Financial Crisis, systemic frictions, hedging demand, and tighter limits on arbitrage have caused forward FX pricing to deviate from the no-arbitrage conditions of CIP. The cross-currency basis has persisted since 2007. It is widening for both short- and long-term

borrowing despite fading concerns about bank credit quality and the introduction of risk-free rates with the LIBOR reform.

Cross-Currency Basis: A Vital Tool for Treasurers

This makes the cross-currency basis (CCB) a necessary tool in a treasurer’s market data package. Using even one CCB for the entity’s most traded currency pair already significantly improves the accuracy of the valuation result.

To understand which specific cross-currency basis spreads fit your use case, it is important to know the valuation perspective of your treasury system.

One possible methodology is to focus on the entity’s functional currency and apply the CCB to the foreign currency’s discount curve. It is a straightforward way to keep the FX risk effects on the foreign currency side of the calculation.

For Eurozone entities that means using CCB spreads that are quoted against the euro. That does not change much compared to the wider known approach of using the spreads that are quoted against USD when a euro entity closes a USD trade. Both currencies are either the functional currency or the trade currency in this use case, and both EURUSD and USDEUR cross-currency basis spreads are readily available on the market.

For example, the advantage of this perspective becomes obvious when a euro entity closes a GBP/AUD trade. In this instance, the entity needs only GBPEUR and AUDEUR cross-currency basis spreads for the valuation and can bypass completely CCB spreads that are quoted against USD:

This approach works for any domestic currency. However, international business poses a higher demand on the quality and quantity of the cross-currency basis spreads necessary for the valuations.

CCBs for some currency pairs or tenors are not readily available from the market data provider. The reason is poor liquidity for the exotic currencies or at the near end of the curve. The liquidity of the whole CCB curve for some domestic currencies can be poor too, making these curves unacceptable for the valuation. Such a gap can influence the pricing process of whole business branches.

ION can close this market data gap. The treasury system supports the calculation of the cross-currency basis as the deviation from the CIP implied pricing.

Continuing with the example above, the methodology involves gathering the following necessary data for the calculation:

  • FX spot rates: GBP/EUR, AUD/EUR.
  • FX date rates: GBP/EUR, AUD/EUR.
  • Yield curves: EUR yield curve for the functional currency (ESTR-FIX), GBP yield curve (SONIA-OIS) and AUD yield curve (AUD-PAR) for the trade currencies.

Cross-currency basis spreads will be calculated for every tenor of the date rate curve. The first data point presents somewhat of a challenge because the 1D tenor of the yield curves often does not match the 1D tenor of the date rate curve. ION solves this issue by using the 1D market rates instead of the discount factors for the first data point.

For the rest of the data points, ION employs the same procedure: the spot rate GBP/EUR, the date rates GBP/EUR, the discount factors for the domestic currency EUR and for the foreign currency GBP enter into the linear calculation of the GBPEUR cross-currency basis spread – see the following graph:

The system repeats this procedure for the AUDEUR CCB curve.

The CCB calculation considers the zero-rate conventions due to employing discount factors. It works for every tenor available in the FX date rate curve, meaning this approach is not limited to the near end of the curve. The user can define the calculated and the imported tenors for every curve. Moreover, this approach is flexible regarding the domestic currency.

This fits with the system’s focus on the entity’s functional currency and means that an entity can calculate the spreads for its domestic currency versus any foreign currency and apply it directly during pricing, making the detour over USD unnecessary.

The additional set-up is minimal. The system automatically calculates whole CCB curves or just the missing tenors from other market data.

The integration of the calculated cross-currency basis tenors is simple. The calculation takes place during the market data import. That means that the calculated tenors fit seamlessly into the curve alongside the imported cross-currency basis tenors. They close the market data gaps.

The subsequent bootstrapping of the zero-rates curve treats imported and calculated cross-currency basis tenors equally. In the final step, the system evaluates the GBP side of the trade using the CCB-adjusted GBP discount factors and the AUD side of the trade using the CCB-adjusted AUD discount factors. All the steps of the process (import and calculation of the tenors, the cross-currency adjustment for the pricing) generate transparent logging for the purposes of audit.

The other use case for the cross-currency basis lies in the hedge accounting. ION supports the currency basis as the excluded component for the derivatives. The currency basis is the difference between the derivative’s clean fair value and the clean fair value of a synthetic trade. The synthetic trade is an equivalent of the original trade without the cross-currency basis spread adjustment. However, the system adds a spread to the synthetic trade to ensure the same starting clean fair value as in the original trade. The currency basis as the cost of hedging is generated every month during the lifetime of a hedge for further booking.

ION’S ITS utilizes the methodology described in this article. It uses imported cross-currency basis tenors alongside calculated ones. The calculation is based on the covered interest parity (CIP) and works automatically with minimal setup. The cross-currency basis is necessary for precise pricing and offers further advantages in hedge accounting. Other ION products offer these functionalities too.

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