Comparing FX Basis Swaps with Rolling FX Forwards for Hedging

Summary

The document frames a hedging comparison for an American issuer with Canadian-dollar bonds and an existing USD/CAD fixed-for-floating swap. The issuer wants to hedge the swap’s floating FX leg, choosing between an FX basis swap and a series of three-month FX forwards. The question highlights that comparing only total hedge cost misses differences in payment variability, payment timing, capital tied up, potential upside forgone, and funding opportunity cost.

No answer or evaluation method is included, so the document does not identify a preferred hedge or provide evidence that one is superior. It raises a broader question about how to compare strategies with different cash-flow patterns and funding demands. A meaningful assessment would need to reflect the issuer’s specific liabilities and constraints, but that framework is not developed here.

Key ideas

• The proposed alternatives are an FX basis swap and rolling three-month FX forwards to hedge a floating currency exposure.
• A cost-only comparison may overlook payment variability, timing, capital usage, and funding opportunity cost.
• The document identifies lost upside as another consideration in evaluating hedge choices.
• No comparative results, recommended metric, or decision framework are provided.

Tags

# Comparing Hedging Strategies


# Comparing Hedging Strategies












Say I am an American issuer, and I've issued some bond denominated in CAD. I've hedged the coupon by entering into an FX USD/CAD fixed for floating swap and I receive the fixed leg and pay floating, paid semi-annually and reset quarterly. Assume this is the only option available to me.

I want to hedge out the FX floating leg of that IR swap now. I can do that by entering into either an FX basis swap, or by rolling 3 month FX forwards (receiving CAD and paying USD at the fwd rate). So essentially I want to compare these two strategies ex-post where the goal is to hedge that floating rate.

Besides comparing the cost of each hedge, what other metrics are available to compare these two strategies? The dollar amount alone doesn't capture certain unique features of each strategy (for instance, variability of payment amounts using forwards vs fixed using swaps; tying up capital using swaps; timing of the payments etc). There are also considerations such as lost upside and the opportunity cost of funds used to hedge. Is there a superior metric that's commonly used when evaluating trading strategies? How are comparative strategies typically evaluated?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.