US Rates Strategy | Special
Please see the last page of this publication for important disclosures.
August 29 2011
Cross-Currency Basis Swaps: The Supply Effect
The EUR/USD currency swap is being used by European financial institutions to fund USD assets when repo lines or raising USD through commercial paper, CDs, or other funding sources becomes too expensive or inaccessible (borrowing dollars). This market is showing signs of funding stress which we look at in some detail below. European corporations, agencies, supranationals and sovereigns use the cross-currency basis swap to swap USD issuance back into Euro (lending dollars). The EUR/USD cross currency basis swap is currently attractive for European issuers looking to issue in dollars and swap it back to euros. For instance, as highlighted below, some issuers could do this and improve their funding levels by over 40 bp. The attractive levels could prompt USD issuance to fund the European bailouts, and if this occurs, we expect the basis to narrow. An increase in the use of the Fed and ECB’s swap lines could also narrow the basis. The main factors that have resulted in a more attractive basis swap include European bank funding concerns, demand for USD from European financial institutions, and a decline in USD issuance from European corporate and SSA issuers. Potential Source of New European USD Supply Our European strategists continue to expect the lending capacity of the European Financial Stability Facility (EFSF) to increase from EUR 256 bn to EUR 440 bn 1 . The increase is subject to parliamentary approval in the EU which is expected to be completed by the end of September or the beginning of October at the earliest. Our European strategists currently think about 25% of the issuance could be in USD which would equate to as much as $158 bn at current FX rates. The exception would be if EFSF issuance ended up being fairly low (i.e. EUR 50 bn or less). As we outline below, the cross currency basis makes USD issuance relatively more attractive for EFSF and other European issuers. If they
Eric Hiller Head of Derivatives Strategy +1 203 897 2652 email@example.com
Ryan Graf Rates Strategy +1 312 664 7085 firstname.lastname@example.org www.rbsm.com/strategy Bloomberg: RBSR<GO>
See The All New and Improved EFSF by our European strategists for more details.
it supplies USD to European financial institutions causing the basis to become less negative. The lopsided demand for USD funding drove the basis negative and an offsetting flow from issuers would reduce the supply/demand imbalance. it is highly likely that such issuance and the swapping activity would push the currency basis back toward less stressed levels. current basis swap levels would makes it very attractive for the EFSF to ramp up USD issuance. Figure 1: Yankee issuance from Euro area corporations and SSA has had a tendency to push the term EUR/USD basis closer to zero
50 45 40 35 Issuance ($bn) 30 25 20 15 10 5 0 Jan-10 Issuance Apr-10 Jul-10 Oct-10 Avg 3yr EUR/USD Basis Swap Jan-11 Apr-11 2M Moving Avg. Bloomberg
US Rates Strategy | Special | August 29 2011
are able to fund in USD at similar local spreads. (Issuance) Jul-11 -25 -30 -35 -40 -45 0 -5 Avg Monthly Basis Swap Level (bp) -10 -15 -20
. When a European issuer issues in USD and uses the basis swap to convert the USD into EUR. In addition. the longer term EUR/USD basis swap levels closely track USD issuance from European corporations and SSA as highlighted below. Dealogic.The Royal Bank of Scotland
Longer Tenor Cross Currency Swaps Affected by Issuance Longer-term cross currency basis swaps are strongly related to supply and demand of USD and have been less volatile than shorter maturity basis swaps as seen in figure 2. In fact.
. Whether or not it ultimately makes sense for a European issuer to issue in USD depends not only on where the basis swap is but also funding levels in each currency.0 7. and open lines reached almost $600 bn at the peak.0 22.0 12. USD from the Fed’s central bank swap lines could collapse the basis. Figure 3: Fed Swap Lines versus 3m EUR/USD Basis Swap
700 600 Fed USD Swap Lines ($bn) 500 400 300 200 100 0 7/2/08 0 -20 -40 -60 Basis Swap (bp) -80
-100 -120 -140 -160 -180
-200 9/2/08 11/2/08 1/2/09 3/2/09 5/2/09 7/2/09 9/2/09 11/2/09 EUR/USD 3m
USD Swap Lines
Source: RBS. If the current funding situation were to worsen.0 17. the Fed ramped up its USD swap lines with foreign central banks.The Royal Bank of Scotland
Figure 2: The EUR/USD basis provides a funding advantage to Yankee issuers which has varied with time and time to maturity
20 0 EUR/USD basis (bps) -20 -40 -60 -80 -100 0. NY Fed. For example. This led to a normalization of the cross currency basis to pre-crisis levels.5 15.5 5.5 30. As part of its effort to deal with the liquidity crisis of late 2008.5 10. the benefits of issuing in USD and utilizing the basis swap include diversification of funding and potentially more attractive funding levels.5 25. Bloomberg
Benefiting from the Wide Basis For European issuers.0 27.0 Maturity (years)
Source: RBS US Rates Strategy | Special | August 29 2011 3
Fed Swap Lines Affected the Basis Another factor which affected the basis in the past was the Fed’s USD swap lines with foreign central banks.5 20.0 2.
one can enter into a 3m FX swap (or a 3m cross currency basis swap which is effectively the same). the European Investment Bank (EIB) can currently recognize a 44 bp funding advantage over where their 5yr EUR debt is trading as seen below 2 . these institutions turn to the FX market. selling euros for dollars on a spot basis and simultaneously selling the dollars back at a future date in an FX swap. buy USD and own the assets. In EUR. Thus. EUR/USD Basis Swap Mechanics To borrow USD.
. This lets the institutions fund dollar assets until the forward rolls off or assets mature or are sold. Instead. A similar spread in USD would imply a level of L + 8 bp. While these institutions could sell EUR. or other funding sources may be too expensive or inaccessible. This level would represent a significant funding advantage for EFSF as it equates to Euribor – 35 bp. NY Fed.The Royal Bank of Scotland
Figure 4: A Cross Currency Funding Example with EIB
5yr Levels Spread (bp) USD Libor + 5 bp EUR Euribor + 5 bp EUR Eqivalent of USD Funding Level Euribor . it also means that EFSF (and other European issuers could issue at significantly wider levels in dollars than in euros and the funding would still be attractive. Bloomberg
Figure 5: Steps to Convert USD Funding to EUR Funding
1) Issuer sells a USD debenture 2) If fixed rate.
What does the basis tell us about funding stress? One of the main drivers of the 3m EUR/USD cross currency basis swap is USD demand from European banks or other institutional investors. Turning this around.39 bp
Source: RBS. These investors need to fund USD assets but repo lines or raising USD through commercial paper. Spreads to Euribor for EUR bonds are spread to 6m Euribor. this would instantly convert a credit decision into a major currency risk. CDs. The institution sells
Note: The cross currency basis swap converts 3m Libor to 3m Euribor. 5yr EFSF currently trades at Euribor + 8 bp or 3 bp wider than EIB.
US Rates Strategy | Special | August 29 2011
issuing in USD and using a basis swap to convert to EUR. issuer uses a vanilla USD interest rate swap to convert those cash flows to floating rate (3mL + spread) 3) Cross-currency basis swap converts USD 3mL payments to 3m Euribor + spread 4) A Euribor 3s6s basis swap converts 3m Euribor + spread to 6m Euribor + spread 5) All of these swaps can be done as one transaction
EFSF has issued three EUR deals to date totaling EUR 13 bn. but it is unclear where USD debt would trade. the Euibor 3s6s basis swap also contributes to the funding advantage.
the basis spread x. However. Putting it in terms that translate directly into Bloomberg functions and custom expressions. the actual funding rates are not equivalent to Libor and Euribor. Thus. in basis points is: X = 10000 * (((1 + US0003M Index * 92 / 36000) * EUR Curncy / (EUR Curncy + EUR3M Curncy / 10000) . the FX swap reflects actual funding rates that can vary significantly from Libor and Euribor.The Royal Bank of Scotland
If e = Euribor and u = US Libor (both in percent) then the usual assumption for the basis swap spread. Parity arguments suggest that the effective cost is supposed to reflect the funding differential (actually the discount function ratio) derived from US and EUR rates. is that the market drop reflects the fact that the borrowing of USD does not happen at “u” nor the lending of EUR at “e” but at two other effective rates u’ and e’. the forward foreign exchange transaction occurs at a less attractive effective funding level. The FX swap expresses the economics in a drop instead of an interest rate spread. I agree to give you back the same number of euros plus interest computed at Euribor plus a spread.EUR003M Index / 100)
US Rates Strategy | Special | August 29 2011
EUR and buys USD spot and also agrees to the unwind 3-months later. Thus. and you agree to pay me back the same number of dollars plus interest computed at Libor. so the basis. is not zero. in percent (for a T day period) is the following: (1+u*T/360)*eur/eurfwd = (1+(e+x)*T/360) In words. With these two expressions we can compute the 3-month basis spread from the 3-month drop. x. The single period crosscurrency basis is the relative difference in funding rates as follows:
. One difference however. An FX swap also converts dollars to euros at the spot rate and then converts the euros back to dollars a new rate when the swap ends (the new rate is the forward rate at the time the swap is entered into). the basis swap level reflects the value of a money-market account in one currency divided by the money-market account in the other currency which is then converted back into a spread to Euribor.1) / (92 / 360) . I should be indifferent whether we enter a basis swap or an FX swap which means that the basis swap spread x neutralizes the effect of the rate settings and the effective funding in the currency swap. which is described as a spread on the Euribor side versus Libor flat. Economically. I give you a dollar on the spot date versus euros. eurfwd/eur = (eur + drop) / eur = (1+u’*T/360)/(1+e’*T/360) = 1 + (u’e’)*T/360 + higher order terms. Given that the market is overflowing with institutions trying to raise dollars in the same direction.
This expression can be used to generate a custom Bloomberg index. The basis to the OIS curves is significantly smaller which may better focus the attention on the source of the distortion—Libor or Euribor and the remaining bias to receive dollars. the FX swap market tends to be more liquid than the currency basis. under the “Defaults only apply to CURRENCIES” section. For a 3-month period. The same basis expression can easily be computed versus USD OIS and Eonia by replacing US0003M with USSOC and EUR003M with EUSWEC. For much longer-terms or multiple resets.The Royal Bank of Scotland
Figure 6: EUR/USD Basis Swap (Calculated with Libor and Euribor)
0 -10 -20 -30 Spread (bp)
Figure 7: Implied EUR/USD Basis Swap spread to Eonia versus OIS
0 -10 -20 -30 Spread (bp) -40 -50 -60 -70 -80
-40 -50 -60 -70 -80 -90 Jan-10
Moving from a 3-month basis swap (or FX swap) to the longer tenor basis swap Adding periods to the basis swap appends a forward starting version of the above calculation. the cross-currency basis swap tends to be much more convenient and converts the full economics into a spread to funding. The forward discounting rates embed a pair of FX forwards which is economically converted into a spread to the Euribor side.
US Rates Strategy | Special | August 29 2011
Where EUR3M is the 3-month FX drop and T was set to an average day count of 92 days as an approximation for the 3-month period 3 . The mid-market basis spread is the spread that brings the total value of the multiple cash flows to zero. However.
. on PDFN <GO>. set the Forward Rates option to 1. Bloomberg’s historical convention defaults for currencies must be set to display points rather than outrights. To ensure this.
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US Rates Strategy | Special | August 29 2011
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