I have tried extensively to find the answer to this both on this website and externally. My question is 'how are FX swap points determined?' but would like to lay out my own understanding first (also for the benefit of others).
I have always been under the impression that you can replicate the FX Swap by transacting an Interest Rate Swap (IRS) in both currencies, which we know is an exchange of fixed for floating cash flows, with the floating leg calculated off the LIBOR or foreign LIBOR equivalent.
We now have a fixed v floating obligation in two currencies, and no exchange of principal. To then replicate the FX Swap, we now trade a Cross Currency Basis Swap (CCBS), which exchanges notional at outset (converted at the spot FX rate) as well as floating interest payments in the two currencies. The direction of the CCBS is traded such that our floating obligations via the two IRS traded previously have no been cancelled out, with the actual basis differential on foreign LIBOR remaining (the premium or discount foreign LIBOR is quoted via the CCBS).
My question in all this is - where do OIS fit in with all this, given they are also fixed for floating swaps that reference the equivalent overnight central bank rate (as opposed to LIBOR) and also there is no exchange of principal. If there was a Basis swap that would negate the floating cash flows in both currencies OIS, I could understand that. But as far as I am aware, that doesn't exist.
I guess my ultimate question is how are we solving fixed interest rates in currencies using the OIS, without an equivalent product to cancel out the floating payments (unless with my example above where using IRS + CCBS replicates a fixed loan/deposit i.e. FX swap perfectly)?
FYI for anyone reading this, FX swaps generally have one notional fixed with the differential cleared in the Spot FX market, at which point you can compare the FX swap to a loan/deposit in two currencies.
EDIT: While I know the mechanics of the CCBS aren't as simple as above, I still think the IRS/CCBS combo replicates an FX swap - if it doesn't, what does? What actual instruments can be used to exploit arbitrage?
Thanks
EDIT#2: Hi Attack68 - I know the FX forward/swap is the interest-rate adjusted spot price. To frame my question another way - how would I replicate an FX forward with various underlying instruments (IRS, CCS [fix of Libor] and/or OIS[fix of OCR])?
Some thoughts: - Commonly held that the CCS is back solved from the swap points under 2 years for most G10 pairs, while the inverse is true over 2 years (CCS is used to solve for forward points). This is why I suspect there is a way replicate the FX Swap/Forward with these instruments. - Where do the OIS fit in with all this then? As I questioned above, given CCS fix off Libor but OIS fix off the OCR, I am a bit confused.
I am mindful of the blow up we saw in AUDUSD CCS over the 18/19 holiday period and it's impact on the swap points, which has made mindful of not truly understanding how the points are derived.
If you could lay out a step wise process that would be helpful - I read from above it is only the CCS you need to calculate the discount factors.
Some thoughts: - Commonly held that the CCS is back solved from the swap points under 2 years for most G10 pairs, while the inverse is true over 2 years (CCS is used to solve for forward points). This is why I suspect there is a way replicate the FX Swap/Forward with these instruments. - Where do the OIS fit in with all this then? As I questioned above, given CCS fix off Libor but OIS fix off the OCR, I am a bit confused.
I am mindful of the blow up we saw in AUDUSD CCS over the 18/19 holiday period and it's impact on the swap points, which has made mindful of not truly understanding how the points are derived.
If you could lay out a step wise process that would be helpful - I read from above it is only the CCS you need to calculate the discount factors.