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Pricing Cross-Currency Basis Swaps with Illiquid Funding

Article Quant Q&A · Author: Eamon
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Summary

The document considers how a bank might price a ten-year EUR/DEV cross-currency basis swap when there is no established swap market in DEV and the proposed hedge is to roll daily borrowing and deposits at the two risk-free rates. Its central point is that the quoted spread should reflect the bank’s exposure to DEV funding, rather than being set mechanically to zero or inferred solely from the bank’s funding curves. In particular, rolling short-term funding to support a long-term position creates substantial refinancing risk if DEV rates rise sharply.

The answer recommends evaluating whether the bank can source long-term DEV funding through domestic deposits, bonds, or other channels, and accounting for the client’s access to the exotic currency in the price. If long-term domestic funding is available, it may help hedge the swap’s DEV exposure; otherwise, the bank may have to retain that risk or decline the trade. The discussion is qualitative and gives no valuation framework for calculating the spread or DV01. Its specific spread suggestion is an individual view, not a market quote or general rule.

Key ideas

  • Rolling daily DEV funding against a ten-year swap creates significant refinancing risk.
  • The basis spread should compensate for the bank’s exposure to changes in DEV funding costs.
  • Long-term domestic DEV borrowing may hedge the swap’s DEV funding exposure.
  • The answer offers qualitative risk guidance rather than a formula for pricing or DV01.

Tags

Fixed incomeForexDerivatives pricingRisk management
Full text
# determine cross currency basis spread in illiquid markets


# determine cross currency basis spread in illiquid markets












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 ?

thanks,

## Answer by Jan Stuller (score 3)

https://quant.stackexchange.com/a/77134

- 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.

- 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.

- 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.

- 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).

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