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I am trying to understand the mechanics of resettable xccy basis swaps and put together a numerical example. I'd like to know if 1) periodic interest payments are calculated on the original notional exchanged at inception or at the reset notional? 2) at expiry how is determined the notional to be exchanged back (at the final FX rate or start FX rate)?

EURUSD xccy swap with 2 reset dates between inceptions and expiry.

EURUSD rate:

start 1.20 first reset date 1.25 second reset date 1.10 expiry 1.40

Notional = $1000

I assume rates are fixed for the sake of simplicity

USD rate = 3% EUR rate = 1% basis = 0.5%

From the prospective of the USD lender I get below cash flows:

start (FX rate = 1.2)

Notional exchange -$1000 +€1200

first reset date (FX rate = 1.25, increase of 4.2%)

Notional adjustment €1200 * 4.2% = €50

Interest received $1000 * 3% = 30 dollars
Interest paid -€1200 * (1% -0.5%) = -€6

second reset date (FX rate = 1.10, decrease of 12%)

Notional adjustment $1000 * -12% = -120 dollars

Interest received $1000 * 3% = 30 dollars
Interest paid -€1200*(1% -0.5%) = -€6

expiry (FX rate = 1.40, increase of 27.3%)

Notional exchange +$1000 -€1200

Interest received $1000 * 3% = 30 dollars
Interest paid -€1200 * (1% -0.5%) = -€6

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First, a couple of notes:

  • if the FX rate is 1,2, then the notional exchange -1000 USD / +1200 EUR doesn't make sense, it should be the other way round,
  • basis is usually added to, not subtracted from, an interest rate,
  • principal adjustment will usually be on the other leg than the one where the spread is (in this case, spread on the EUR leg and adjustment on USD),
  • USD LIBOR is being phased out in favour of SOFR and market conventions around RFR (compounded overnight) CIRS aren't yet well established I think - it may be the case that principal reset feature will disappear.

Answering your questions:

  • interest is calculated off the adjusted notional,
  • final notional exchange is that amount, with which last interest was calculated,
  • a notional adjustment basically works as if old notional was being returned and new notional was being paid afresh, to be used for the subsequent interest period,
  • a useful rule of thumb is that all principal cash flows should sum to zero.

The cash flows in the example would look like this:

  • Initial principal exchange at FX rate 1,2: -1200 USD / +1000 EUR
  • First interest exchange: +1200$\cdot$3% USD / -1000$\cdot$(1%+50bp) EUR
  • First principal adjustment at FX rate 1,25: +1200-1250 USD
  • Second interest exchange: +1250$\cdot$3% USD / -1000$\cdot$(1%+50bp) EUR
  • Second principal adjustment at FX rate 1,1: +1250-1100 USD
  • Third interest exchange: +1100$\cdot$3% USD / -1000$\cdot$(1%+50bp) EUR
  • Final principal exchange: +1100 USD / -1000 EUR
  • Each interest exchange and corresponding principal adjustment happen on the same date.
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  • $\begingroup$ Welcome to Quant.stackexchange! $\endgroup$
    – noob2
    Mar 10 at 0:11
  • $\begingroup$ thanks! Very useful. Can you just confirm 1) if the (initial) notional of the swap is usually quoted in USD (in this case $1200) or not? 2) How are usually used these products (what counterparty is interested to have a resettable notional)? $\endgroup$
    – Student
    Mar 10 at 10:24
  • $\begingroup$ Regarding 2) - the principal reset feature has been invented mainly to limit the counterparty risk. If you have a constant notional CIRS and the market FX rate moves far from the one used at inception, the deal will acquire a huge NPV and thus exposure to the counterparty, which brings credit risk charges, CVA etc. Big NPV is also inconvenient because it consumes balance sheet. So periodic notional reset serves to eliminate this accumulated NPV. It's primarily used between dealer banks, because they care about such things. End users, who use CIRS to hedge funding, rarely do notional reset. $\endgroup$
    – Adam N.
    Mar 10 at 16:47

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