I have a very special case, where a client needs a quote on a cross currency basis swap EUR/DEV, DEV is a hypothetical currency where the market for cross currency swaps is inexistant. client wants to give EUR nominal and receive DEV.

the only possible hedge for this swap is daily borrowing/deposits at the 2 Risk free rates (ESTER, and DEV RF). Let's say that these daily borrowings in DEV/deposits in EUR are possible for the investment bank for the time being, how much should the bank price the basis spread ? should it be zero ? or should the actual 10Y funding curve of the bank for each currency be used to get the basis spread that makes the MtM of the swap equals to zero ? also, let's say this swap is traded, what would be DV01 on funding curves and on the spread ? is there anyway to hedge the DV01 on the spread (equivalent 10Y duration) ? or must the bank just sit on this risk ?



1 Answer 1

  1. Your main risks are sourcing the DEV notional. By entering into the swap you are short the 10Y funding in DEV and long the 10Y funding in EUR. Your main decision is to decide how to hedge the short 10Y funding in DEV.
  2. You say that the "only possible hedge for this swap is daily borrowing/deposits at the 2 Risk free rates (ESTER, and DEV RF)": for EUR, this is certainly not the case, there are many instruments available to "hedge" (i.e. FX swaps ranging in maturities all the way up to 10Y, or if your bank can fund itself in EUR, you have other options too), but your main concern is the DEV funding anyway: lending out the DEV notional for 10Y and borrowing it over a 1-day period is pretty risky. I imagine that DEV is some sort of EM currency: just remember what happened to Turkish Lira overnight funding a few years back: it temporarily exploded to something like 6000% (annualized) and the people who were short Lira funding for longer maturities and were hoping to hedge it via rolling shorter borrowing lost a lot of money.
  3. Your spread should take into account the risk described above (i.e. DEV short-term funding exploding). Also, the other bank is giving you EUR and asking for the exotic DEV, so you should deff charge them something for providing this service. Last but not least, I would never trade this unless my bank actually had access to the domestic onshore DEV funding, and ideally not just a short-term one with the central bank, but also via deposits or otherwise (bonds, etc.): otherwise it's too risky in my view.
  4. If you actually can issue DEV bonds or have access to DEV deposits, this could be a very nice trade: you would then hedge the 10Y short DEV on the swap via similar-maturity long DEV sourced domestically, and could charge a nice spread on the EUR/DEV basis (I'd charge at least 15 bps).
  • 2
    $\begingroup$ Completely agree with 3. Never do this unless you have the domestic capacity to operate in DEV currency. There is a reason that local domestic banks are typically the ones involved when Issuers want to Issue in other market currencies and swap it back to their own market. $\endgroup$
    – Attack68
    Oct 24, 2023 at 16:30
  • $\begingroup$ I totally aagree, just a random though. As an EM/frontier country grows more developed,, generally (there are exceptions), instruments become available in this order - primary government debt in local currency, then secondary, then offshore FX forwards and criss-currency swaps versus USD and EUR, then onshore fixed for float locall currency IR swaps..my point being, perhaps you can buy a government bond? If 10y doesn't exist, maybe 3y or 5y, then roll. $\endgroup$ Oct 30, 2023 at 11:48
  • $\begingroup$ @DimitriVulis: agree with the order in which liquidity becomes available. However, the risk is that on T+1 (or T+2) you need to deliver the DEV notional: where will you get this? If you can short the Government bond and keep borrowing it, then that could work. But how would buying the bond hedge the need to deliver the DEV notional for 10y? $\endgroup$ Oct 30, 2023 at 12:12
  • $\begingroup$ Apologies, I must have misunderstood something. Eamon (the OP) wants to pay fixed amounts of currency DEV far in the future. I th8nk, the exact cash flow amounts are known now. Have I missed some detail? Sorry. $\endgroup$ Oct 30, 2023 at 12:59
  • $\begingroup$ @DimitriVulis: "client wants to give EUR nominal and receive DEV" -> my take on this was that the client wants to receive DEV nominal at inception (so will be paying DEV interest rate). So the task is to source the DEV nominal and fund it for 10Y. Your idea with the Govies is actually a really good one: usually, the local ministry of finance holds a portfolio of bonds that it is happy to lend out in repo (usually two-week): if that's available, we can short the Govie and keep borrowing it from Min Fin: but it's still risky, if the repo rate (tied to local bank rate) explodes. $\endgroup$ Oct 30, 2023 at 15:49

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