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Webcast: The Mechanics of Cross Currency Basis Swaps

Speaker: Dr David Cox

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A course on this topic is available in New York Time Zone, London Time Zone and Singapore Time Zone

Webcast Agenda

  • How a CCBS works
  • Market quotation
  • Drivers of the Basis Swap spread
  • Impact of currency supply and demand
  • Relationship between Basis Swap spread, Overnight and Libor rates
  • Basis swap adjusted yield curves
  • Valuation of cross currency cashflows
  • IRS collateralized in non-swap currencies


1. Why are there no forward points included in the final exchange on a CCBS?
A. The reason for that is that the interest rate differential, which will generate your forward points, has been settled on a quarterly or possibly on a semi-annual basis in the form of Libor. So, the interest rate differential has been paid and therefore you don't need to incorporate it in the final exchange in the form of forward points.

2. Why has there been a change from Libor to OIS discounting?
A. What we have had over the last 10 years or so is a much more detailed consideration of the way we value cash flows on the basis of collateral having been posted against those cash flows. If you think about the posting of collateral to support the cash flows on the swap, if the swap cash flows go away, the funds that you have in the form of your collateral have to be invested and be able to replace the missing cash flows from the defaulting swap.

What if you ask what rate of return you get on your invested cash and thinking about the majority of cash collateral being in cash, the return on your cash is going to be the overnight rate - you can put on deposit and earn the overnight rate. Well, that means that the future cash flows, which are being supported by that cash collateral which you have in the bank today, need to be discounted at that same overnight rate. So, that is really the reason for using overnight rates for discounting.

Now in maybe 10 years or so ago, people were not so careful about their consideration of the value of their collateral and discounting was done at libor, which simplified a lot of calculations but did not really give us the precise economic value of the swaps.

3. Can I replicate a basis swap with FX forwards?
A. The basic answer is yes, but it is very messy. In the very early days of cross-currency swaps people used to do that. You would do a long-dated cross-currency swap with the counterparty and then go into the foreign exchange market using foreign exchange forwards in order to replicate the future cash flows on the cross-currency swap. The trouble with that is that the cash flows coming from your forwards - and due to the forward points - would not match the cash flows that the client would require from the cross-currency swaps, leaving you a small gap which needed managing. And of course the management of that was being done by the money desk in the institution quoting the swap, and those cash flows were small and untidy, and costly to manage. Therefore, the cost of managing those cash flows caused it to be very expensive to replicate cross-country swaps in that way.

The other thing is if you just think about the number of tickets you have got to write to replicate a single cross-currency swap with a series of FX forwards, it is a lot. If you think about the transaction costs and the processing of those FX forwards, well again it just all increases the cost of the cross-country swap. So, the answer is yes, but it is expensive - you can do it, but it is not an ideal replication to try and execute.

Thank you to those attendees who submitted their questions.

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