Rates Radar. More interest in cross-currency basis swaps. Interest Rate Strategy. For important disclosure information please see pages 19 and 20.

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1 Interest Rate Strategy Rates Radar More interest in cross-currency basis swaps The current fixed income environment of negative rates in Europe and rising rates in the US makes it imperative for many global investors to look abroad, and hedging the FX risk attendant upon foreign assets becomes critical. The cross-currency basis a persistent anomaly in the FX hedging world since the financial crisis becomes highly relevant not only for traditional hedgers like treasury departments, but also for investors in their global search for yield. We provide an intuitive understanding of what the basis swap is and how treasurers and investors can utilise it. 8 March 2017 The story of cross currency basis swaps originates with the start of the floating currency market regime in the late 1970 s / early 1980 s, as corporations and investors with global reach sought methods of insuring themselves against sharp currency movements. Forward FX rate contracts became popular. The forward rate calculation is trivial, and any deviation in the market from the calculated rate implied by interest rate differentials gives traders a chance to do arbitrage trades, which made such deviations unlikely. And yet, since 2008, such deviations have persistently emerged. They are expressed in the market as the cross currency basis, which is a spread to one of the Libor interest rates used to calculate the forward FX rate 1. We plot this basis below; it is remarkable how large and persistent it can be, given that before 2008, arbitrage activity maintained it at almost zero. In this primer we sketch the theory and technical aspects underlying the fx basis, explain why a persistent non-zero basis has emerged since 2008, illustrate how investors and issuers can take advantage of this market distortion, assess recent developments in the basis and new regulatory treatment under IFRS9. The start of the financial crisis marks the end of arbitrage-free global rates 1y EURUSD xccy basis in bp Source: Bloomberg, Commerzbank Research 1 The authors owe thanks to the many colleagues who contributed. In particular we would like to thank Matthias Ebert of the DCM Bonds Origination Group who is the source of information about the conversion factor, the originator of the table on sources of the basis and the 4-factor issuer matrix. We are also most grateful to Adrian Williams of the Corporate Solutions Group who supplied the regulatory information and chart. We will later define this spread precisely and show how to calculate it. For important disclosure information please see pages 19 and 20. research.commerzbank.com / Bloomberg: CBKR / Research APP available Analysts Prof. Jessica James Michael Leister, CFA michael.leister@commerzbank.com Christoph Rieger

2 The calculation underlying the cross-currency basis swap A quick note on terminology An FX forward is a contract that locks in the price at which a counterparty can buy or sell a currency on a future date. The exchange rate is typically today s rate, adjusted for the interest rate differential in the two currencies. If the interest rate in the local currency is higher than that of the USD (or whatever the reference currency is), the FX forward will include a devaluation expectation. In a cross-currency swap, the parties exchange a stream of payments in one currency for a stream of cash flows in another. The typical cross-currency swap involves the exchange of both recurring interest and principal (usually at the end of the swap), and thus can fully cover the currency risk of a loan transaction. Conceptually, cross-currency swaps can be viewed as a series of forward contracts packaged together. For much more detail on moth of these, see Appendix B. Perhaps the simplest formula in financial mathematics The calculation to discover the forward rate is trivial. It is found using the expression FF SS = 11+rr ff 11+rr dd (1) where F is the forward FX rate, S is the spot (current) FX rate, r f is the foreign interest rate and r d is the domestic interest rate 2. The FX rate must be quoted as units of foreign currency per domestic currency, for example, 1.1 USD (US Dollar) per EUR (Euro). EURUSD is the conventional way of quoting this in the market. This calculation arises very simply. There are two ways of getting from holding the domestic currency now, to holding the foreign currency in the future. Method 1. Invest now for the period in question, at the domestic interest rate, then exchange at the end of the period Method 2. Exchange now so that you hold the foreign currency, and invest at the foreign currency rate for the period EUR F USD per EUR USD 1 + rr dd 1 + rr ff EUR S USD per EUR USD Arbitrage pricing would tell us that Method 1 and Method 2 must be exactly the same, apart from perhaps some small trading spread effects, or there will be a chance to round trip the system and make some risk free money (arbitrage). Conventionally, and in the pre-crisis world, this will only occur in a small and transient manner, as sharp eyed traders look out for the chance and thus keep pressure on the forward rate to comply with equation (1). This type of situation traditionally (pre-crisis) has arisen in small and temporary forms, quickly eliminated by arbitrage trading. Thus this method of calculating the forward rate was thought to be completely robust. How could it possibly be incorrect in any substantial way? 2 Note that this is the nominal interest rate rather than the real interest rate. 2 8 March 2017

3 But as we will see, even this apparently unbreakable piece of mathematics is vulnerable to unforeseen market effects. The existence of a non-zero cross currency basis breaks equation (1). How the calculation distorts no-arbitrage pricing The relationship in equation (1) is protected by arbitrage constraints, which one would think, in this era where both humans and machines comb the market for strategies and opportunities, would be sufficient to ensure its integrity. However, market size and liquidity are not enough to ensure perfect efficiency. In Appendix A, we show that the FX market has been by some definitions markedly inefficient since its origins as a floating rate, by allowing a profitable carry trade to persist. And we can present simple evidence that an acute distortion of equation (1) has occurred, and moreover persists to this day. Let us go back to the equation. FF SS = 11+rr ff 11+rr dd (1) If EUR is the domestic currency, and USD the foreign, then a quick re-arrangement gives us rr dd = SS FF 11 + rr ff 11 (2) Now, all of these rates are readily observable in the market. To check it out precisely, we calculated r d using equation (2), and compared it to the market rate since Before about 2008, the calculated value of r d matches the value of r d obtained from the time series EUSW1V3 Curncy, the EUR 1 year swap rate. But after that date, they vary considerably, sometimes by up to 1%. If we plot the difference, calculated using r d-theoretical - r d-market, then we obtain the following graph (yellow line). We have added to the graph the quoted xccy (shorthand for cross-currency) EURUSD 1y basis swap (black line) The degree to which the arbitrage pricing is violated is almost exactly equal to the market quantity known as the cross currency basis swap. Interest rate difference, with quoted xccy basis Theoretical 1y EUR interest rate actual 1y interest rate, in bp, with quoted basis theoretical - actual 1y EUR interest rate 1y EURUSD xccy basis, market data Source: Bloomberg, Commerzbank Research It s clear to see that apart from a few not-so-good data points they are essentially the same. So what is going on? Essentially, equation (1) is no longer holding, and has not held since 2008, even between EUR and USD, the world s largest currencies. This degree of violation is called the basis or basis swap and it is expressed as the difference between the non-usd interest rate (in this case the 1 year EUR swap rate) implied by the FX forward, and the actual market value of this rate. Here s a quick example taken from one of the more extreme recent periods (grey circle in the graph above). 8 March

4 On 29 th December 2011 EUR-USD xccy basis EURUSD spot FX rate EUR 1Y swap rate USD 1Y swap rate = 101.9bp (EUBS1 Curncy) = (EURUSD Curncy) = 1.094% (EUSW1V3 Curncy) = 0.691% (USSA1 Curncy) EURUSD 1Y FX forward = (EUR12M Index) Using equation (2), we calculate the theoretical EUR 1Y swap rate EUR 1Y swap rate (theoretical) = rr dd = SS FF 11 + rr ff 11 = 1.296/1.304 x ( %) -1 EUR 1Y swap rate (theoretical) = 0.073% But the actual swap rate is not %, it is 1.094%. The difference is 0.073% % = % = bp 3 And this is almost exactly equal to the quoted basis in the market, %. Of course, that is not the only way to express the inequality! We could equally well plot the difference between the theoretical FX forward rate, derived from the spot rate and the interest rates available in the market, and the actual quoted rate, F theoretical - F market. Then we would create the following: Forward rate difference Theoretical 1y EURUSD forward rate actual 1y forward rate, units are rate difference Source: Bloomberg, Commerzbank Research And if we wanted, we could rotate the whole situation once more and arrive at a spot FX rate difference. Though this is probably not the best way to view the issue, a shift to the spot rate would be just as valid to explain the market mismatch! We have illustrated the situation using the 1 year rates, only because they involve the least amount of arithmetic. But one may exactly repeat this analysis for tenors from 3M to 30Y, and the same relationships will hold. So however we look at it, the forward rate calculation is broken and not even in a transient way the basis seems to have moved in and is here to stay! So what actually is a cross currency basis swap? It s worth explaining exactly what this means, and also what is meant when folk refer simply to the basis. A cross currency basis swap (often abbreviated to xccy basis swap ) can formally be set out as in the figure below. Here, we assume that an institution starts off with EUR funding, which it converts with a basis swap to USD funding. This could be a EUR based issuer which 3 Note that market convention usually has the basis in bp though interest rates would more normally be in % 4 8 March 2017

5 has sold a EUR bond locally, and so already has EUR bond cashflows, like coupon and redemption, but would rather convert them to USD. Practically, most sub-1-year hedging is done using currency forwards (a single exchange at the final date) whereas longer term hedging tends to be done using swaps (final exchange plus interim interest rate exchanges). The central figure is the contract known as the cross currency basis swap, where there are initial and final exchanges of capital (both at the spot exchange rate at the start of the deal) and interim floating rate interest rate exchanges. At the start of the deal both currency legs will have the same value, but of course as FX rates vary then the value of the deal can change. Variations in interest rates will have only a small effect as the interest rate cashflows are all floating; the next coupon is the only one which is known and fixed. EUR funding 100m EUR Company receives proceeds from bond sale 3m EURIBOR Floating bond coupon payments 3m EURIBOR 3m EURIBOR Bond redemption 3m EURIBOR 100m EUR plus Basis Swap 110m USD 100m EUR 3m EURIBOR 3m EURIBOR 3m EURIBOR 3m EURIBOR 3m USD LIBOR 3m USD LIBOR 3m USD LIBOR 3m USD LIBOR 100m EUR 110m USD equals USD funding (net position of issuer) 110m USD 3m USD LIBOR 3m USD LIBOR 3m USD LIBOR 3m USD LIBOR 110m USD The quantity often somewhat confusingly referred to as the basis is an adjustment to the central basis swap agreement. The basis is the result of supply and demand for USD cashflows. Strong demand for USD cashflows means that the EURIBOR interest rate available for the deal is not the one which will make the PV of the EUR and the USD legs equal; it is a little less, and this difference is the basis. It is exactly what we calculated in equation (2). The reader can already see that a basis which can be larger than 1% will be highly significant to issuers and investors. Conversion Factor Before we go on to discuss the various drivers of the cross currency basis, it is worth introducing one more effect, often neglected. This is because when we discuss the motivations of issuers and investors, the cost of issuance is strongly influenced by one additional item the conversion factor. The conversion factor is the number of basis points per annum in one currency that equates to 1 basis point per annum in another currency, thus it varies with the tenor and 8 March

6 structure of the interest rate curves of the two currencies. It is important to remember that it does not depend upon the FX rate, where 1 basis point in one currency is 1 basis point in the other, at all times. Another way of thinking about the conversion factor is that it comes from different convexities in the two currencies and is thus dependent both on interest rate curves and spread levels. Where interest rate differentials are small, the conversion factor will make only a small difference to the rates - typically just 1 or 2 basis points - but where the differentials are large the difference may be quite significant. To convert from basis points in a non-eur currency into basis points in EUR: If the non-eur rates < EUR rates, then EUR conversion factor > 1 If the non- EUR rates > EUR rates, then EUR conversion factor < 1 Or vs the USD, If the non-usd rates < USD rates, then USD conversion factor > 1 If the non-usd rates > USD rates, then USD conversion factor < 1 Example for conversion factor calculation as of 20 Feb 2017 Interest Rates (as of 20 Feb 2017) Tenor 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y USD 1.30% 1.56% 1.75% 1.90% 2.01% 2.09% 2.18% 2.26% 2.32% 2.38% EUR -0.21% -0.15% -0.07% 0.02% 0.13% 0.26% 0.38% 0.51% 0.64% 0.75% Discount Factors USD EUR Conversion Factors Source: Commerzbank Research The conversion factor of a particular tenor is given by ratio of the sum of the discount factors up to that point of the different currencies so for the 10 year point, it is the sum of all the EUR discount factors, divided by the sum of all the USD discount factors. This tells us that the 10Y EUR-to-USD conversion factor is currently basis points. Hence, a credit spread of 400bp over the EUR IRS swap curve translates into 400 x = 436bp in USD. In order to swap the EUR instrument into USD you would need to further add the EUR/USD currency swap costs as well as the EUR basis swap cost of 39.5 bp (as of 20 Feb 2017). Finally, you might have to consider the Libor frequency of the EUR and USD legs. If the EUR leg is 6m, as is market standard, and the USD leg is 3m, as is also often the case, then the 3/6 EUR swap costs will also need to be added. If the two legs are the same then this cost is zero. The above example shows that the conversion factor element in cross-currency swaps made around 48% (or 36bp) of the overall swap costs of 76.0bp if the credit spread of the instrument is 400bp in February We note that an advantage for an issuer is a disadvantage for an investor, and vice versa. Thus, investors looking to buy bonds can apply exactly the same analysis to find where they may get the best value. In the current QE-dominated environment of last year, EUR asset scarcity tended to force many EUR investors into USD assets. Things are now more complicated as USD credit spreads have tightened substantially post the Trump election, thus for shorter tenors, USD investors might well be attracted by EUR spread levels. Where does the cross currency basis come from? The basis mainly arises from FX funding and hedging needs In brief, the basis arises because issuers prefer to match the currency mix they have on the asset side with the currency mix on the liability side while investors prefer to hedge their FX risk. If an issuer cannot obtain sufficient foreign currency funding (as happened during the 2008 financial crisis when European banks had to fund lots of dollar assets but had lost access to the dollar funding market), they can create synthetic foreign funding via domestic funding in combination with FX forwards (in the FX market) or basis swaps (which belong more to the rates market). This can create a mismatch in the supply/demand for foreign funding and the hedging instruments. As long as the access to foreign funding remains distorted between domestic and foreign issuers and market participants lack balance sheet or credit lines to arbitrage away the 6 8 March 2017

7 distortion, there will be pressure for the basis to exist. In general, this hedging need translates to demand for certain currencies, often the USD. For a good explanation of these causes and effects, see references [2] and [4]. Below is a rough illustration of the different potential sources of the basis. It centres on issuance of debt in different countries and currencies. Note that the top boxes and the bottom boxes balance each other if the top boxes dominate, the basis becomes more negative; if the bottom box effects grow, the basis becomes less negative. Issuers and the xccy basis Situations in which issuers would be USD payers USD Payer swap : USD funded, wish to raise EUR Why? Tight EUR credit spreads relative to USD Result: More negative basis Current situation: Balanced effect. Given the US credit spread tightening after the Trump election relative to, the funding advantage for US issuers has become less compelling and so-called reverse yankee issuance has subsided (for most of last year, the effect was large) Investors and the xccy basis Situations in which investors would be USD payers USD Payer swap : EUR based, EUR synthetic investment Why? Asset diversification, capture higher yields abroad Result: More negative basis Current situation: Modest effect. While there is significant asset scarcity due to ECB purchases, the credit spread pick-up in the US has become less compelling. Foreign dollar portfolios with rolling fx hedges at the front end also appear less attractive at the moment given prevailing fears of faster Fed hikes. Source: Commerzbank Issuers and the xccy basis Situations in which issuers would be EUR payers EUR Payer swap: EUR funded, wish to raise USD Why? For some products and tenors, it is cheaper to issue in USD Result: Less negative basis Current situation: Moderate effect, most significant in longer tenor instruments where the conversion factor is large and ECB purchases less relevant, or in short tenors for highly rated entities like KFW where the EUR credit curve is very flat. Source: Commerzbank Investors and the xccy basis Situations in which investors would be EUR payers EUR Payer swap: USD funded, but EUR investment Why? Asset diversification Result: Less negative basis Current situation: Small effect, tight spreads and elevated political risks in euro area make assets less attractive for foreign investors Source: Commerzbank Source: Commerzbank Some explanation of these terms is useful. USD (EUR) payer swap: owner of a cross-currency basis swap which changes their net position from paying USD (EUR) floating rates to paying EUR (USD) floating rates. Credit spread: the difference between rates which a company pays on its own curve (in USD respectively EUR) and the IRS curve for the same currency 4. When we hear that credit spreads are tight it means that demand for corporate debt in that currency is high, so the cost of debt is relatively low. Negative Basis: the difference between the actual interest rate for a currency and the theoretical interest rate calculated using the FX forward rate, FX spot rate, and (usually) the USD interest rate. When the actual rate is less than the theoretical rate, the basis is negative. Let s think of the situation in which an issuer finds themselves when they need to issue debt. They want to do it in the most economical way. For a USD issuer, the ground zero or best 4 The swap curve may be considered to contain credit risk of an average large financial institution so it is not completely risk free 8 March

8 possible level could be considered to be the IRS curve in USD (although some highly rated entities like GE can even trade inside the swap rate at the short end). The cost above that level is the credit spread due to their own issuer quality, or USD spread. Similarly, the cost of issuance to a euro area issuer is EUR spread. The cost of issuing in another currency, and then hedging the FX risk of the issue, will depend on the credit spread in the other country for companies of similar quality, the cross-currency basis, and the conversion factor 5. So, now we have the full rationale which companies must bear in mind when making their issuance choice: For the USD entity, they will issue in EUR (and buy USD payer xccy basis swaps) if USD spread > EUR spread * Conversion Factor + xccy basis This is the case for entities like SSSAs where the ECB PSPP is active. For the EUR entity, they will issue in USD (and buy EUR payer xccy basis swaps) if EUR spread > USD spread * Conversion Factor+ xccy basis This would most frequently be the case for higher spread products (AT1 and T2, high yield issuers) where there ECB is not active, and where for longer tenors the conversion factors are very favourable. Issuers take advantage of cheaper credit spreads in other currencies The situation last year, as shown in the boxes in the above figure, was that there was relatively more EUR issuance and buying of USD payer xccy basis swaps, and thus there was pressure on the basis to become more negative. As an example, consider a US firm on 20 Feb 2017 whose bonds have a 200bp credit spread over the US swap rate. The subsidiary of the firm in Europe can issue bonds which have 100bp credit spread over the EUR swap rate. The basis is 39.5bp, and the conversion factor is USD spread = 200 bp EUR spread = 100 bp * bp = 148.6bp Thus they ll be about 50bp better off if they issue in Europe. The effect of this long term behaviour is to skew the effective USD interest rate higher. However, this skew will differ from one currency pair to the next as credit spread and other effects persist to different extents in different markets - thus the market expression of this USD demand as a spread to the non-usd interest rate. Another way of putting it is that s counterparties impose increasingly large spreads on the trade which only ever seems to go one way! Euro area supras and agencies are the prominent counter example, as they actively cover their EUR funding needs in the USD market and hence take advantage of the basis. Another significant reason is currency mismatches on the balance sheets of large financial institutions. As yields change, balance sheets may be structurally biased towards or against specific currencies. FX derivatives like swaps will have to be used to cover any currency gaps between assets and liabilities, which will place pressure on equation (1) again. So here again, imbalances in the supply and demand for currency hedging result in a non-zero basis, as these institutions are usually fully FX hedged. Additionally, strategic hedging on the part of investors with foreign currency holdings can also apply pressure to widen (= make more negative) the basis. Once more the hunt for yield sends the market into foreign territory! But portfolio allocation ratios, once established and prevalent, move only slowly and thus another persistent currency hedge position can exist. The desirability of a currency is closely connected with yield, and one good indicator of this is the FX carry trade. The G10 FX carry trade is the result of allocating funds to higher yielding 5 Credit spreads are general quoted vs 3m Libor/Euribor etc so any deviation from this will mean that the 3s/6s basis may also need to be considered 8 8 March 2017

9 currencies by borrowing in the lower yielding currencies. Below we can see that this trade correlates closely with the EUR-USD basis swap, showing that the basis is strongly influenced by yield and thus ultimately central bank policies. However, as can be seen on the chart, during stress periods like 2008 and 2011/12, the basis is highly volatile and can significantly decouple from the carry/yield proxies. Cross currency basis swap with FX carry 5y EURUSD basis swap (bp, rhs) with G10 FX carry 6 (index, lhs) Source: Bloomberg, Commerzbank Research What keeps the basis swap from being arbitraged away? We can see why there might be one-way pressure on the forward rate/libor rates, but traditionally, an equal and opposite pressure would be provided by arbitrage activity which would bring rates back in line with our friend equation (1). Perhaps the important question is not why does the basis swap exist because we know that pressures and temporary dislocations often occur in financial markets. The true question is, why does it stay? There are quite a few reasons as to why it persists, and they are all to do with the more stringent regulatory regime governing the markets since the crisis, which ultimately prevents markets from balancing supply and demand for FX hedges. We list the more significant ones below. Capital cost of FX derivatives The regulatory burden of holding different deal types on books has changed. The derivatives like cross currency swaps which are used to arbitrage the currency imbalances described in the previous section all involve capital flows often substantial at the end date. These will require large amounts of risk capital to be held against them! Thus there will be a limit to how many may be done, and a cost to doing them, as the risk capital used to protect them will be in safe low yielding instruments. Arbitraging will thus entail a cost and have a limited extent, for most institutions. Counterparty risks and Credit limits Arbitrage activities require counterparties and the credit quality of the counterparties limits the exposure that one institution can have to others. Thus large leverage and high risk deals can only occur with a limited set of counterparties and to a limited degree. In that regard, the varying cost and availability of repo funding across jurisdictions limit the extent to which leveraged investors can arbitrage the basis away. Clearing FX carry index (SGI) Eur-USD 5y basis swap Cross currency swaps are not eligible for clearing with many of the world s larger exchanges. Non-cleared derivatives tend to attract a higher cost of funding and the introduction of bilateral variation margining for uncleared trades this month makes it difficult to execute trades as numerous legal CSA amendments have not yet been signed. Though currently there are some This is the SGI GX G10 carry index, BBG ticker <SGIFXC10 Index>, one of several commonly used indicators of FX carry in developed markets. It has a risk weighted allocation and is rebalanced daily. 8 March

10 exceptions made for the currency market, in general the delays to implementing clearing for these deal types impose yet another limit on their number and extent. Horses for courses Of course, there are a few institutions who can do the arbitrage to a degree. But that degree will vary. For a highly rated cash rich organisation, which could issue bonds in USD and take advantage of the basis to do a swap to the end date to deliver value in a different currency, then the cost of placing bonds is important. For a large hedge fund, price and availability of funding to provide the large arbitrage cash flows will be paramount. For a useful discussion of the causes of the basis, see [3], which also argues that the dominant reason for its persistence are regulation-driven balance sheet costs. How could an institution make money from the cross currency basis swap? There is money to be made! This is the burning question! And there is no definitive answer, as different institutions will have very different situations, needs and relative advantages. But the graph below suggests that at least for some folk, for some of the time, there is money to be made. We have calculated a yield pickup for 1Y government bonds. We assume that the investor is based in Germany, and can hold (and short via repo if necessary) bonds in Germany, the USA, Japan, the UK and Australia, i.e. with similar rating or perceived credit risk. The yield pickup is the bond interest rate differential hedged for the 1Y period via the cross-currency swap market, including the basis. Thus the pickup is given by bbbbbbbb ssssssss + bbbbbbbbbb where bond and swap are the 1Y yield differentials for the relevant instruments in each currency. Writing it in this way shows clearly where the dislocations arise. If the spread of bond yield to swap was the same in both currencies, the first two terms would cancel out. If then the basis were zero there would be no pickup at all. So it is due to differential market views on credit and to the basis. Below is the time series of this yield pickup since the end of 2008 for the different currencies. The second graph focuses on the EURUSD case, showing bond and swap and the basis separately. We see that the time series contain different correlation zones. (1) sees both JPY and USD with a negative basis from the EUR investor s point of view; in 2008, clearly both were seen as safe havens from the crisis storm. In (2) in 2011 however, the JPY correlates more strongly with AUD than USD, and only the USD is seen as the true safe haven in the first of the Greek debt crises. More recently in (3), both USD and JPY maintain a negative basis but short range movement of the JPY basis can correlate with more risky currencies. Finally, we see in (4) that all four currency bases are going lower vs the EUR, quite possibly indicating a general nevousness about the euro area in a time of multiple elections, where political surprises and reversals are becoming the norm March 2017

11 Yield pickup, with potential arbitrage opportunity levels Pickup for a EUR based investor, using 1Y foreign govt bonds, in % USA Japan UK Australia 4 Source: Bloomberg, Commerzbank Research EURUSD yield pickup components (%) EURUSD yield pickup components (%) Swap-bond differences for 1y EUR and USD govies The addition of the basis makes a significant difference Delta Bond Delta Swap Delta Bond - Delta Swap Source: Bloomberg, Commerzbank Delta Bond - Delta Swap + Basis Delta Bond - Delta Swap Source: Bloomberg, Commerzbank Is this pickup really available in the market? Not entirely this assumes no repo costs and ignores credit issues and cost of capital. But nevertheless, it is rarely lower than 30bp for any currency, and often greater than 50bp. For different institutions, there could be opportunities at some level. To illustrate where opportunities can arise, below are graphs for KFW and EIB bonds, both issued in EUR, and issued in USD swapped to EUR, as of February Note that the conversion factor is not included in these graphs though for these highly rated institutions it is small. KFW bonds EIB bonds Effective rates for issuing in EUR or in USD swapped to EUR, % Effective rates for issuing in EUR or in USD swapped to EUR, % y 2y 3y 4y 5y 6y 7y 8y 9y 10y KFW EUR KFW USD->EUR Source: Bloomberg, Commerzbank y 2y 3y 4y 5y 6y 7y 8y 9y 10y EIB EUR EIB USD->EUR Source: Bloomberg, Commerzbank 8 March

12 Recent Developments Higher short-end volatility The EURUSD basis swap has been active recently. Various special factors caused an extreme widening ahead of year-end in shorter tenors. Firstly, the US money market reform enacted in October caused a structural shortage of dollar funding at international banks. On top of this, the Trump election led to strong USD demand as market participants speculated that the dollar would strengthen significantly in the Trump era. And finally, seasonal effects over balance sheet reporting dates have become more pronounced. The year-end balance sheet reporting date always affects the basis but the effect was very powerful at end Due to tighter regulations there were instances of banks paying short term interest rates of 40% for dollars over the turn in the fx swap market. Since the turn, all of these factors have not only disappeared but actually gone into reverse, leading to a tightening in the basis in the first part of Anomalous current situation with xccy swaps and conversion factors Historically, a strongly negative basis tends to be connected to a conversion factor of less than 1. This means that they tend to offset each other. However, QE pressures seem to have driven the basis to very negative levels even as differing economic regimes in the USA and Europe mean that the conversion factor is becoming large and positive, as seen in the chart below. EURUSD xccy basis swap and conversion factor 10y EURUSD basis swap (bp, rhs) with conversion factor (ratio, lhs) Conversion Factor Lehman USD funding crisis Eurozone sovereign debt crisis Eurozone QE QE xccy basis swap in bp QE Y EUR/USD Conversion Factor 10Y EUR/USD xccy basis swap Source: Bloomberg, Commerzbank Research The implications of this regime are interesting. Below is a diagram showing the optimal issuer behaviour under different regimes of basis swap and conversion factors, assuming that spreads for outstanding bonds remain stable March 2017

13 Optimal Issuer Behaviour Optimal issuer behaviour as a function of market regime EURUSD xccy basis swap < 0 Non-QE eligible bonds EURUSD Senior/covered funding in USD/ Subordinated funding in EUR Senior/covered funding + Subordinated funding in USD EURUSD QE eligible bonds move down Senior/covered funding + Subordinated funding in EUR EURUSD xccy basis swap > 0 Senior/covered funding in EUR/ Subordinated funding in USD QE eligible bonds Source: Bloomberg, Commerzbank Research The matrix is based on the assumption that the credit spread for the instrument is the same in EUR and USD (e.g. 100bps). If the conversion factor is >1 AND the basis swap is <0 then it is cheaper to issue funding and capital in USD (currently the case) However, as our assumption about equal credit spreads does not hold in a world of extensive buying by the European Central Bank, we end up in a situation where credit spreads for senior/covered bonds are notably lower in EUR than in USD. Hence, issuers of purchasing programme eligible bonds (Eurozone SSSA, corporate senior, financial covered bonds) face a situation in which senior/covered funding is more attractive in EUR and subordinated funding more attractive in USD. The choice of the currency for subordinated funding is notably influenced by the conversion factor as subordinated funding is usually a product with a longer term and a higher credit spread. The funding choice for higher-rated paper (covered bond for financials and/or senior bonds for corporates) however is largely a function of the basis swap as tenors are usually mid-term and credit spreads are lower. Thus our current situation with USD subordinated but EUR highgrade/senior funding favoured is relatively unusual and the result of QE programme and its influence on secondary EUR credit spreads and USD/EUR conversion factors, at a time when the Fed is raising interest rates. What will happen if the ECB stop their purchases? A straightforward answer is that euro area credit spreads will widen, leaving the USD relatively more attractive to issuers. However, this is somewhat simplistic. If the ECB activity slows, the EURUSD xccy basis is likely to respond by tightening due to an easing of the EUR asset scarcity. Thus we could see wider spreads and a less negative basis, which may well offset each other. Additionally, if the divergence between the USD and EUR yield curves reverses, the conversion factor will become smaller. Thus the effect on the likely product/currency mix is more difficult to predict, with $ credit spread developments also needing to be taken into account. New regulatory regime The International Accounting Standards Board, IASB, is releasing a new International Financial Reporting Standard, IFRS 9. It replaces IAS 39 in Several developments in IFRS 9 amend the handling of cross currency swaps in IAS 39. Perhaps the most important change for the cross currency basis is that currently, the valuation of a cross currency swap held by a company incorporates the impact of the basis, but when it is designated as a hedge under IAS 39, the designated hedge omits the basis. This leads to considerable P/L volatility. Under IFRS9, however, that valuation of the swap does not include the basis. Rather, it is designated as a cost of hedging and expensed over the term of the swap on an accrued basis, and so the mark-to-market volatility is largely reduced. 8 March

14 A concrete example is given below. We show a hedge of a $100m 5y USD Fixed Rate Bond issued by a corporate in 2008, swapped back to floating EUR. The hedge is a pay EURIBOR / receive USD fixed Cross currency swap. The effective hedge allowed under accounting rules is designated as the hypothetical derivative. This hypothetical derivative is described as a fair value hedge of the bond revalued into EUR. The chart shows the value of the hedging swap including basis and the hypothetical derivative without basis. FX and interest rate movements dominate the relationship as can be seen from the fact that the yellow and black lines are very close to one another the basis is introducing a small but discernible error, as shown by the grey line. Example of cross-currency basis 5y xccy swap with and without basis, and resulting ineffectiveness (bp) Swap revaluation (EURm) (5) (10) (15) (20) (25) (0.2) (0.4) (0.6) (0.8) (1.0) (1.2) (1.4) Ineffectiveness from XCCY Basis Source: Bloomberg, Commerzbank Research At the time of issue, the cross currency basis was relatively small but would have increased to cause P&L volatility of up to EUR 1.2m (or circa 1% of notional) during the life of the trade. This would not have been significant enough to cause the effectiveness to fail but does create unexpected noise which has deterred some corporates from using swaps. Under IFRS 9 the basis could be excluded from the hedge relationship and amortised over the life of the swap Overall, the accounting problems implicit in handling cross currency swaps have contributed to the (regulatory) cost of basis arbitrage. However, although this accounting change might provide relief, it is unlikely to reverse the balance sheet cost issue. Appendix A: The FX Carry Trade A historical view UIP and CIP 7 UIP the first to fall XCCY Swap with basis (actual MTM), LHS XCCY Swap value excluding basis (matches revaluation of bond), LHS Ineffectiveness due to basis, RHS The first way in which the FX market declined to obey market expectation was Uncovered Interest Rate Parity (UIP). In the early days of the floating FX rate regime, it was assumed that spot rates would on average follow the path laid out by the forward rates. The forward rate path predicts (from equation (1)) that the higher nominal interest bearing currency will depreciate relative to the lower interest rate bearing currency 8. This does not on the face of it seem unreasonable investors in higher-yielding (higher inflation) currencies get compensated for the currency weakening by higher interest rate income. Put differently, higher interest rates exist due to higher levels of risk (for example regarding inflation and central bank expectations), thus to assume that more risky currencies will depreciate relative to less risky ones is plausible. Uncovered Interest Rate Parity is said to hold if currencies follow, on average, the forward rate path 9. 7 Uncovered Interest Rate Parity and Covered Interest Rate Parity 8 Note that if real (as opposed to nominal) interest rates are higher in one currency than another, they are likely to attract investment and thus strengthen the currency. Thus inflation plays a crucial role. 9 Note that this should be true only if high nominal interest rates are closely linked to high inflation. Inflation acts to weaken a currency; high nominal interest may rather act to attract investment March 2017

15 It is useful for market participants, risk managers and quants if UIP does hold. It means that the arbitrage pricing is correct on average and does not allow for systematic trading strategies to deliver profit, and it means that the middle office risk management of long term positions within financial institutions can use the same valuation models as the front office traders. But, it does not hold. The devaluation of currencies implied by their interest rate regimes does not, on average, occur. As the evidence mounted that UIP is violated [5], and that forward rates have no predictive power over the path of spot rates, the market and various academic institutions reluctantly had to admit that this particular assumption was invalid. We may summarise the evidence with the following graph, taken from reference [1] and updated. Cumulative returns to the FX carry trade, % Quarterly returns from all EM and G10 FX crosses, averaged Example of carry trade, from low to high yielding ccy Numeric example, EUR/BRL Feb 2017, 1y forward Cumulative return (%) Total carry Spot component Forward point component Required spot path for UIP FF = SS 11 + rr ff 11 + rr dd F = forward FX rate = 3.60 = weaker high yield ccy S = spot FX rate = 3.29 r f = foreign interest rate = 9.15% r d = domestic interest rate = -0.11% If spot at expiry < F = 3.60, long forward trade makes a loss/ sold forward trade makes a profit If spot at expiry > F = < 3.60, long forward trade makes a profit/ short forward trade makes a loss On average, we find: spot at the start of the deal is a better predictor of spot at expiry than the forward rate, therefore the carry trade on average makes money. Source: Bloomberg, Commerzbank Source: Commerzbank This is the result of pursuing a systematic rules based quarterly carry trading strategy in all liquid currency crosses, both G10 and EM (heavy black line). A carry trade is where the trader takes a position against the forward rate (same as doing a short forward trade), borrowing in the lower yielding currency to lend in the higher yielding one. If the spot rate does move to the forward rate, then the trader will make no profit. If the spot rate stays the same and does not move over the course of the deal, the trader will make exactly the forward interest rate differential (known as forward points) this perfect carry trade is represented by the fine grey line. The central heavy grey line is the actual average path of the spot FX rates. As can be clearly seen, the actual carry trade gives almost identical results (with some noise) to the perfect carry trade. This is the same as saying that on average, FX rates do not move toward the forward rates, they are more likely to be the same as the spot rate at the start of the deal. So UIP bites the dust. What about CIP? CIP surely invulnerable? CIP (Covered Interest Rate Parity) was thought to be a much harder nut to crack. Covered Interest Rate Parity is said to hold if equation (1) holds. However, as we have shown, the existence and persistence of the non-zero cross currency basis clearly shows that indeed, CIP has fallen as well. Appendix B: The Cross-Currency Toolkit The three elements There are different financial products available to allow investors and issuers to adjust their currency exposures. The most liquid and widely used are FX Swaps FX Outrights (or Forward Outrights) Cross Currency Basis Swaps Each serves different sections of the market and is useful in different ways. Below we explain the mechanics of each and their major users. 8 March

16 FX Swap Below is a schematic of the cashflows involved in an FX swap between parties A and B. We assume we have a principal amount P in EUR, and that the current spot FX rate is S USD per EUR, with a forward rate F. Start End A A P EUR P x S USD P EUR P x F USD B B Definition of FX swap: Party A borrows Currency 1 to lend Currency 2 Usual Maturity: up to 1Y Uses: FX swaps are mostly a liquidity and treasury management tool. Users are Asset Managers: investors in overseas markets who don t want currency risk. Lenders of domestic currency vs the foreign currency they need to fund Bank Treasurers: they wish to lower their cost of funding and liquidity in different currencies Central Banks: manage their liquidity profiles Corporate Treasurers: act like banks for their own short term funding, manage their treasury position in different currencies Note that the basis is embedded into the forward rate, so though it is not explicit in the diagram, it is certainly included. FX Outright (Forward Outright) Here we show the cashflows involved in an FX Outright (often called Forward Outright) between parties A and B. We again assume we have a principal amount P in EUR, and that the current spot FX rate is S USD per EUR, with a forward rate F. Though simple in concept, in execution this tends to be done as a swap plus a spot transaction. Start A End A P EUR P x F USD B B 16 8 March 2017

17 Definition of FX swap: Party A and Party B exchange Currency1 for Currency 2 at a future date. In fact it is usually done as a spot trade plus a swap, as below. Spot Trade Start FX Swap End A A A P EUR P x S USD P EUR P x S USD P EUR P x F USD B B B Usual Maturity: below 1Y or 2Y FX Outright Uses: This market tends to be extensively used by corporates and exporters, to cover trade and repatriation flows As before, the basis is embedded in the forward rate. Cross Currency Basis Swap Below we now include the interim interest payments included in a cross currency basis swap. Start A During term A End A P EUR P x S USD EUR 3m Libor + basis USD 3m Libor EUR 3m Libor + basis USD 3m Libor P EUR P x S USD B B B Definition of FX cross-currency basis swap: where two parties borrow from, and simultaneously lend to, each other an equivalent amount of money denominated in two different currencies for a predefined period of time, including floating interim interest payments, usually 3m. Usual Maturity: up to 30Y in some cases, though up to 10Y is more usual Uses: Primarily used by debt issuers SSAs: natural multi-currency users. Different locations will have different currency mixes. Corporates: some large corporates can act like SSAs. Others may use EUR or USD as funding currencies, swapping back to USD. Banks: treasuries minimise cost of funding and liquidity. They vary according to location. Some derivative desks manage the currency risk of different counterparties with xccy swaps. Asset managers hardly ever use this market due to high cost of capital and regulatory constraints. As they would be the natural arbitrageurs in this space, the non-zero basis can persist. The basis is explicit in the EUR Libor flows. 8 March

18 References [1] James J, Fullwood J and Billington P 2015 FX Option Performance: An Analysis of the Value Delivered by FX Options since the Start of the Market (New York: Wiley) [2] Claudio Borio, Robert McCauley, Patrick McGuire, Vladyslav Sushko 2016 Covered interest parity lost: understanding the cross-currency basis, BIS Quarterly Report Sep 2016, [3] Wenxin Du, Alexander Tepper, Adrien Verdelhan 2016 Deviations from Covered Interest Rate Parity, SSRN, [4] Fumihiko Arai, Yoshibumi Makabe, Yasunori Okawara and Teppei Nagano, 2016, Recent Trends in Cross-currency Basis, Bank of Japan Review, [5] Fama, E.F., Forward and spot exchange rates. J. Monet. Econ., 1984, 14, March 2017

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