Comparing FX Forward Rolls and Cross-Currency Swaps for Bond Hedges
Summary
The document considers hedging a USD corporate bond into GBP using either rolling three-month FX forwards or a cross-currency swap, with rates risk hedged separately through interest rate swaps. It asks how to compare the approaches’ costs as an effect on the bond’s Z-spread. The answer says a proper pricer is needed and identifies forward points as a key cost for the rolling-forward approach and cross-currency basis as a key cost for the swap approach.
The comparison may also depend on payment frequency and additional curves, such as tenor basis and OIS curves. Rather than forecasting future basis for the swap, the suggested approach uses the available cross-currency basis curve. For a spread comparison, the answer suggests converting the bond into floating exposure and comparing its cross-currency asset swap spread with the local-currency asset swap spread, described as close to Z-spread. It offers no worked example or quantitative results, and notes that an FX-implied Z-spread is possible but not commonly used.
Key ideas
- A proper pricing model is needed to compare rolling FX forwards with a cross-currency swap.
- Forward points and cross-currency basis are central to the respective hedge costs.
- Payment frequency can make additional curves relevant to the calculation.
- The proposed swap comparison uses the quoted cross-currency basis curve rather than forecasting its future level.
- Asset swap spreads can provide a practical spread comparison, though the document gives no worked calculation.
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Full text
# FX Hedging costs when using 3m FX Fowards vs XCCY swaps for an IG Bond
# FX Hedging costs when using 3m FX Fowards vs XCCY swaps for an IG Bond
Suppose I want to hedge the FX exposure of an USD Corp Bond(held to maturity) to GBP and I can choose between rolling 3m FX Forwards and XCCY swaps. How can I estimate the difference in the hedging costs of these two approaches in terms of their impact on the Z-Spread ?
My understanding is that I need to forecast the behaviour of the 3m currency basis over the lifetime of the bond and compare it with the basis that I'd lock in the xccy swap. Could you point me me towards som research that would help me answer this question ?
ps. let's assume that the rates exposure is hedged separately using IRS
## Answer by oronimbus (score 4, accepted)
https://quant.stackexchange.com/a/63639
To get an accurate answer you probably won't be able to get around using a proper pricer and comparing the two methods. To contrast the two approaches:
The main risks will indeed be the forward points for method 1 and the XCCY basis for method 2. However, depending on the payment frequency of the bond, you might need to factor in several other curves as well, e.g. 3s6s or 3s12s basis or OIS curves. You don't need to forecast the 3m XCCY basis per se since you a have a full XCCY basis curve up to 30 years or so. This is what your pricer will rely on.
The hedge cost differential would then just be the difference $c = YTM_{CCY2} - R_{CCY2}$. You could also compare the implied basis from covered interest rate parity versus the quoted XCCY basis. Generally the two should align relatively well though.
If you want to do a comparison in spread terms then you could use method 2 and swap into a floating interest rate instead which would give you a XCCY ASW (asset swap spread). This can be directly compared to the local currency ASW (which is close enough to the Z-Spread). For the first method, I've never seen an FX implied Z-Spread being used (although it's mathematically possibly of course).
There are many books that cover these topics in detail but perhaps a bank primer such as this one is sufficient.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.