Negative Cross Currency Basis Swap - By JP Morgan

CFA Level III Derivatives
#1

I’m reading an article about high yield debt and active issuance of european corporates issuing debt in the US.

Can someone explain what they mean by bold statement below:

"we expect active issuance to continue due to: increasing funding diversification by EU issuers, the great depth of the USD market and a persistently negative cross currency basis swap?

What do they mean by that?

#2

Probably that the rate on a cross-currency swap is negative (versus a normal positive rate) to the LIBOR party due to negative short term rates seen recently, a recent phenomenon due to the payments due cash versus bonds to the ECB for holding assets. Hope you reveiwed your swaps before the recent level 2 exam…

#3

If you build the swap rate using LIBOR, I don’t recall LIBOR being negative? what I think they are saying is that after taking into account fx, issuing debt in USD is cheaper than using the Euribor, hence the negative basis.

Anyone! Please correct me if I am off here.

#4

A standard CCBS is a float-float between USD and any other currency (say EUR in your case). When we say where is 10y EUR-USD CCBS trading, we are referring to the spread that is added to the non-USD side - say x bps to EURIBOR.

As you know the pricing is based on zero NPV at the start for both legs, so given the forward curve for both currencies, we want to calculate what shall we add to the EUR side, so it equals USD side.

Conventionally, that spread has been +ve (however not necessarily) but recently the steepness on the long end part of the EUR curve means, for long dated CCBS, it is negative to equate it with USD leg.

The way CFA curriculum covers derivatives pricing is completely out of date, its overly simplifies and had some validity before recession but certainly not afterwards due to use of OIS curves for discounting rather than LIBOR (and other changes)

Level two said, at every cash flow settlement date, float rate leg trades at par - thats not correct.

Lastly, “If you build the swap rate using LIBOR, I don’t recall LIBOR being negative?”, short end of the CHF and some of the scandinavian currencies has been negative for a few months. So its plausible, because it is relatively recent (not quite, happened around 2 years ago for the first time) phenomenon CFA curriculum doesn’t cover it.

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#5

So if I were a corporate in Europe, and needed to issue debt in US, I would look at the CCBS as see which is spread is better for me.

So if the spread is negative because the long end of the curve is higher in EUR than in USD making the coupon negative, I would want to issue in USD?

#6

Can you expand on what you mean by " a recent phenomenon due to the payments due cash versus bonds to the ECB for holding assets."

I dont know how this would make the spread negative?

#7

Any thoughts?

#8

You are mixing two things here…

  1. Cross Currency Basis Spreads are to LIBOR or equivalent of two currencies involved. And recall LIBOR/equivalent is unsecured interbank lending.

LIBOR and CCBS spread involved is not the cost of borrowing for a corporate.

  1. Again going back to the basic of corporate borrowing, say a EUR company can borrow can x% in EUR and x+y% in USD, CCBS is essentially helping that company to reduce the borrowing in USD from x+y% to somewhere in between x% and x+y%.

The premise of cross currency swap is that two borrowers are borrowing in the currency of relative advantage and then swapping the same to reduce the cost of borrowing. If EUR company was able to borrow the USD at the same rate as US company, yes it would issue in USD. But it cant and hence…this mechanism.

Does it make sense? Sorry i know i haven’t explained it very well.

Morgan Stanley issued a series of paper called FX Pulse, if you really want to get into inside out of this concept using real examples of spreads, FX basis etc, try to take a read.

I will try finding out, in one of those papers, they really went back to the basics and explained the derivation and pricing of CCBS spreads.

#9

Thanks for getting the time to respond.

Just to clarify this concept further, this is my understanding.

  1. There are two curves
  • LIBOR (USD) = 0.25% 3 month LIBOR (assumption)
  • EURIBOR (EUR) 0.30% 3 month EURIBOR (assumption
  1. The CCBS in the case above would be
  2. LIBOR + Spread ( 0.25%+0.30%), which essential gives you the EURIBOR

In the article above the say " the spread is negative"

So this means that :

  • LIBOR (USD) = 0.30% 3 month LIBOR (assumption)
  • EURIBOR (EUR) 0.25% 3 month EURIBOR (assumption
  • Spread = -0.5%

Questions:

  1. Would this intice EUR companies to swap?
  2. Is it not cheaper to enter into a CCBS because the spread is negative?
#10

  1. Using your example (which is fundamentally incomplete and i will come back to that), why would you swap 0.25% vs. .0.30% ( i suppose you meant the other way around).

  2. Above is not right, when you compare inter-currency interest rates, you have to look at them in conjunction with forward FX rate.

Higher rate in one currency will indicate its depreciation vs. the currency with lower interest rate (interest rate parity), unless there is an arbitrage.

  1. I mentioned when i wrote earlier that the idea of CCBS is not plainly about interest rate in one currency vs. other (using LIBOR, EURIBOR etc).

The underlying point is due to lack of its presence, creditworthiness in foreign market, EUR company won’t be able to borrow at the same rate as otherwise equally credit worthy domestic company in US. And the same holds for US company in EUR.

So they both borrow in local currencies and swap it to reduce respective cost of borrowing.

  1. Answer to all your questions and thought process is embedded in " how the ccbs is priced/valued". Dont perceive it in a negative way, but your post suggest to me you arent clear with the basics.

So i suggest you take material from google, read it and we can take it from there. Happy to fill the gaps but i cant fully explain it in a paragraph or two.

#11

Mission!

No offense taken! Thanks for sharing your knowledge with me.

But I am still unclear.

I understand how swaps are priced and valued…and why corporates in different countries will swap. What I cannot understand is why in this JP morgan report…they especifically call it out, see below.

“we expect active issuance to continue due to: increasing funding diversification by EU issuers, the great depth of the USD market and a persistently negative cross currency basis swap?

Why are they focused on the negative CCBS?

I can’t rationalize the “negative currency swap” part.

thanks!

#12

ANyone?

#13

Is this understanding correct? In a cross ccy basis swap where one leg is USD and other is CAD, negative basis means US investor will pay less interest on CAD amt and positive basis means US investor will receive more interest on USD amt

#14

According to the curriculum, in a USD/CAD swap the basis (positive or negative) is added to the CAD payment; the USD payment is unaffected. (More generally, the basis is added to the non-USD leg. They make no mention of what happens when both legs are non-USD; say, a CAD/EUR swap. I should think that on the exam they’ll have to tell you to which leg the basis applies.)

#15

In EOC Q5, its posiitive basis and applies to lender of USD…And yes you are right, they asked in the question - the US investor will most likely increase the periodic net interest payments received from the swap counterparty in: - And answer is USD dollars…

#16

It’s a bizarre question. The US investor will pay EUR and receive USD. Looking only at that, you would think that the answer is USD: that’s the only thing that the US investor is receiving.

However, it asks about the net interest payments. In that case, you can compute the net either by converting USD to EUR, or by converting EUR to USD. In either case, the US investor receives a higher amount, so the answer should be C.

And, of course, they’ve gone against the rule they mentioned in Example 7 that the basis is applied to the non-USD leg of the swap.

Apart from that, Example 7 also says that covered interest rate parity usually doesn’t hold, which is absurd. Uncovered interest rate parity usually doesn’t hold – there’s no reason that it should – but covered interest rate parity always holds because it’s . . . well . . . covered (i.e., guaranteed by a forward/futures contract).

Sigh.

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#17

I am stuck at this question too:
the basis applies to the payment leg (meaning the currency you are borrowing in the swap agreement).

The case with USD - CAD was borrow USD ( for investing in US LBO) and lend CAD. here it is borrow EURO (for investing in italian bonds) and lend USD for the swaps.