if someone could provide some clarity on the below:
- What is meant by 'Implied FX-OIS Basis'? For example: "ON JPY trading at parity, 1W implied OIS basis moved 70BP" and "3M Implied OIS basis moved 25 BP to imply -130 BP (3M LIBOR XCCY is +4 )". My attempt: We have Interest rates implied by FX Swap points compared against what the points would be had we used the term OIS rates for the underlying currencies - the difference being some basis swap (would imply an IBOR v OCR swap if I am correct) against which we can measure, lets call them dislocation, in FX swaps points that strip out the forward looking expectations of OCR rates by the market?
2a. A client wants 5y EURUSD FX Forward Points (mid) - what instrument(s) do we observe to derive the points from spot? I am explicitly asking this way as once we establish the relevant instruments to observe, I will then gain an understanding of what drives FX points beyond the simple 'interest differentials'/CIP most examples use that are sub-1y and just observe actual IBOR data to create a rate curve. My attempt below:
With reference to this topic: Calculating Cross Currency basis swaps, I have access to my own Bloomberg/access to FXFA - it would appear we observe direct or inferred IBOR rates in each currency (short-end: published IBOR rates, such as actual 3m LIBOR, or 3m LIBOR derived from listed futures or FRA, long-end: IRS). BBG then shows us the difference between FX Swap Implied from those curves and Actual FX Swaps points - the difference being attributable to the XCCY Basis Swap. So in effect we need 2 of the following 3 to solve for the third: IBOR curves (whether actual or observed from the market), XCCY Basis Curve and Actual FX Swap Points. Correct?
2b. Let's assume we have two currencies with completely identical interest rate term structures, however the basis is very positive - say IBOR+100bp for the non-USD currency. The points should then be negative by virtue of the interest rate premium implies by the XCCY basis swap on the LHS currency (non-USD/USD)? I am trying to gauge how changes in XCCY Basis impact FX Swap points, although they would appear to be mostly driven by IBOR differentials with some spot component, having graphed FX points vs the difference between term swap yields in various currencies. By spot component, I would also also ask that - in an imaginary world where interest rates are exactly the same between two currencies (both current and implied forward), but the spot rate is 10% different between T and T+1 (nothing else changes) - the swap points would also change?.
2c. Let's assume balance sheet constraints and credit concerns are non-existent and 5y EURUSD points are wildly off market from what we have calculated from point 2a above - how do we arbitrage this in practice? I am asking this, as I believe I have structured this line of questioning so that the answer should be via the instruments observed in 2a. There has to be some upper/lower bound to FX points once arbitrage becomes attractive enough.
Addition: I want to articulate the mechanics of what we are doing - we are borrowing/lending an amount of fixed currency X, against which we are then lending/borrowing a variable amount of currency Y - so we need to know what the effective term deposit/lending rate in each currency is. Given one leg of an FX swap is normally fixed, the difference for the market maker is cleared in the spot market such that the future amount is the fixed notional also, but this adds/subtracts from the notional of the variable amount, which is why the points have some sensitivity to the absolute level of the spot rate.