Mechanism of Cross currency basis swap (EURUSD)

USD against Euro for a long time has been range bound even though data in USA on average has surprised on upside, and corporate profit beating expectation left right and center and Europe kicking the cane every time it come across a possible disaster except a few moment of eureka like LTRO. Second thing is EURUSD cross currency basis swap (XCCY), Which generally widen when you see companies from eurozone finding it difficult to fund in USD. Recently the forex swap line extended by Fed to ECB and other central banks had brought a kind of sanity to XCCY market, though that proved temporary. EURUSD XCCY 5 Year again back to 40bps. So there is a disconnect between and credit and currency market. iTraxx/CDX is trading at a bit north  of 1.4 from a level 0.8 in 2010. Let us analyse some technical factors underneath, iTraxx main and CDX main is composed of 125 most liquid investment grade names and every six months they roll over and new names enter the index at the expense of few discarded ones. US saw a few name move out due to credit event and Europe which generally does not allow big company to default (they are national champions!!!) so banks keep feeding money even though their credit metrix deteriorates (one reason US credit market is dominated by bondholders 80/20 and Europe credit market by bank loan, 20% bank loans and 80% bonds where bankers have personal relation with top executive and keep rolling loans making it less valuable when the company default). So bottom line is churn out ratio of index constituents is higher in CDX than iTRaxx, second most important thing is financial. They constitute 20% of total index (25 financial names in iTraxx main) and US financials are off course in a much better shape than European, given the high correlation between banks and sovereigns. So one tend to wonder why Euro is not weakening more, given the uncertainty and crisis has reached to door of its 2^nd,3^rd, 4^th and 5^th largest economy namely France (political), Italy and Spain (debt and growth)  Netherland (political). One reason may be USD itself faces a lot of pressure in risk on scenario with a very accommodative monetary policy and Fed bloating its balance sheet by USD 2.3 trillion after financial crisis, 2^nd is political deadlock in an election year. We have seen the hara-kiri last year over debt ceiling negotiation and we may see it again when Bush tax cut expire. Let us try to understand it from the XCCY perspective.

Let us analyse the mechanism of cross currency funding, keeping in mind that the issuer need to fund Euro assets.

Suppose issuer is funding euro-denominated assets, and can issue either USD or EUR bonds at L+100bps in each respective market. This issuer decides to issue in USD. Why? The answer has much to do with the FX basis, which makes USD funding look cheaper once the cost of swapping back to EUR is considered.

Step 1: The issuer elects to issue into the USD bond market, paying USD Libor+100bps on $100 MM of bonds (1). At the same time, the issuer enters a simultaneous hedging transaction with the swap dealer.

Step 2: The issuer pays the dealer the $100 MM raised in the bond market for €75 MM (i.e., today’s spot exchange rate) (2). An agreement is also made to reverse the transaction, at the exact same exchange rate at the bond’s maturity, which will deliver $100 MM back to the issuer to cover the bond’s principal at maturity.

Step 3: During the term of the swap, the issuer receives USD Libor on the $100 MM ‘lent’ to the dealer and pays Euribor plus or minus an amount ‘X’ on the €75 MM ‘borrowed’ from the Dealer. This spread (‘X’), the cross-currency basis. At present, the five-year EUR/USD basis is quoted at -40bp, meaning that the issuer will pay the dealer €Euribor- 40bp in exchange for a stream of $Libor+0bp payments.

Computing the cost: Taken all together, the issuer:

*Pays $Libor+100bps to the bond market

*Receives $Libor+0bp from the dealer

*Pays the dealer Euribor -40bps

The $Libor flows cancel out, and the issuer is left paying Euribor-40bp +100bps, equivalent to paying approximately Euribor+60bp. Thus, provided the issuer’s funding cost in EUR is greater than L+60bp, issuing in USD at L+100bp may be appealing.

http://www.bloomberg.com/quote/EUBS5:IND/chart

(Cross currency basis swap spreads against USD Libor as of 25 April, 2012 for 5 years)

Driver of the FX basis.

Now the question is what drives FX basis ? ‘Supply & demand’ simple explanation.

If the swap market is being asked to lend more in EUR (in exchange for USD), the higher the rate on EUR it will charge. Thus, as more European companies issued in USD and made the corresponding swap, one would expect the rate on the €Euribor leg to rise from €Euribor-40bps to, say, €Euribor-20bps, reflecting marginally higher EUR borrowing costs. In doing so, the EUR/USD FX basis would rise from -40bps, to -20bps. Conversely, if the market were filled with companies issuing in Euros, and then looking to swap this into dollars, Euros would become plentiful and dollars more scarce. In turn, swap dealers would offer to pay a lower and lower rate on the Euros they were receiving in exchange for USD, causing the EUR/USD basis to be more and more negative.

Since in the time of stress access to USD funding for Eurozone corporate / banks become difficult so the demand to swap USD in Euro also falls, leading rates to fall. Thats what we have seen recently, however we have not seen the corresponding level of depreciation in EURUSD.

Does it indicate we may see Euro depreciating after US in near future, probably YES given the bigger problem Eurozone face. Its only a matter of time.