Similarly to tenor spreads in single currency interest rate markets, basis spreads between cashflows in two different currencies widened significantly after the financial crisis, resulting in the classic interest rate parity not holding anymore. This means that it is not the same to exchange one US-Dollar now into Euro and invest in Three Months Euribor, compared to investing one US-Dollar in Three Months Libor and entering now into a fair forward to exchange the resulting US-Dollar amount in three months’ time into Euro.
The Euro value achieved by these two investment strategies would not be the same anymore! The difference is caused by the currency basis that has been included in fair fx forwards since the financial crisis and is not reflected in Euribor and Libor rates. It would imply a clear arbitrage opportunity that market participants could exploit and hence should disappear. Reasons why the currency basis has not disappeared since the financial crisis are changed liquidity preferences by market participants regarding currencies and the supply of money in the different currency markets, influenced by differing central bank strategies.
Thus, we have to adjust our model world to capture these effects and such prevent it from implying theoretical arbitrage opportunities, where there are none. To incorporate these effects and make our two strategies yielding the same payoff again a spread (positive or negative) has to be introduced on either the Libor, or the Euribor side. This spread is called cross currency basis. It can be implied form market traded instruments, such as fx forwards and cross currency basis swaps.
Hence, it is important to incorporate this cross currency basis spread information into the valuation of any cross currency deal (fx forwards, cross currency swaps, etc.). Otherwise, the valuation would not reflect current market conditions and practice in valuation and pricing of such derivatives. Therefore, valuations not taking these effects into account are not in accordance with the requirements set out in IFRS 13 regarding the determination of fair values. Exemplified: Someone not incorporating cross currency basis spreads into his valuation should observe significant non-zero market values for actually fair fx forwards at deal inception when valuing them via his own valuation engine, e.g. a Treasury Management System.
Unfortunately, this results in cross currency derivatives having different values depending on whether it is priced from an US investor’s (discounting using Libor rates), or that of an Euro zone investor’s (discounting using Euribor rates) perspective. The difference in valuation reflects the change in currency basis between inception of the deal and valuation date.
Our experts in the Finance and Treasury Management Team would be glad supporting you in regard of any questions arising from the valuation of financial instrument. Further, we provide a variety of services in the context of treasury system implementation and optimization.
Author: Ralph Schilling, Manager, firstname.lastname@example.org
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