For an asset manager wishing to invest in non-domestic markets, management of the foreign currency risk is a key consideration in deciding whether to pursue a given opportunity. FX swaps can be used as an effective hedge instrument to manage currency risks and to potentially enhance the yield available to the investor.
FX swap transactions are often used to manage currency positions on a short-term basis, and can be thought of as a combination of two offsetting currency transactions separated by time.
An FX swap is executed when you swap one currency for another on a nearby value date (“near date”) only to reverse the transaction on a subsequent value date (“far date”). A large proportion of FX swaps entail a spot trade as the near date transaction, while the far date transaction can range from a date inside a week out to a full range of dates, i.e., one week, two weeks, one month, two months, and so on.
CME FX Link provides a cleared, standardized, and credit-efficient alternative to bilateral FX swaps, with the near date involving a OTC spot trade and the far date involving a deliverable FX future. Once the FX swap hedge has been initiated via CME FX Link, the resulting futures position can then be rolled forward on a monthly or quarterly basis as required to match the underlying investment.
As a result, in addition to understanding the potential yield available from investing in domestic or non-domestic assets, the investor also must understand how the FX swap market is being priced in order to calculate the full potential return on their investments to compare like for like. The CME FX Swap Rate Monitor takes actual levels being quoted within the CME FX Link market in order to highlight the inputs in the current FX swap market as well as the implied interest rate differential that these inputs create.
This information can be used to identify potential investment opportunities, and FX Link then can be utilised to execute the FX Swap risk as needed.
A US asset manager has the ability to either invest in domestic USD credit or foreign (e.g., EUR) denominated credit. Any investment outside of USD will incur currency risk, which then needs to be managed as part of the overall investment strategy. As such, the investor needs to compare the potential returns of the domestic USD credit versus the combined return of the EUR-denominated credit plus the associated FX Swap.
Trading a FX swap enables the customer to convert their USD cash into EUR via the spot trade with which they purchase the foreign asset. On sale/maturity of the asset, the far leg of the swap enables the client to transition the EUR back to their ‘base’ currency (USD in this example).
The covered interest rate parity principle is a theoretical condition that suggests the forward rate will be dictated by the difference in short-term interest rates between the two currencies. Under this theory, the price of a three-month (90-day) forward:
However, the covered interest rate parity principle needs to be amended to include the consideration of the cross-currency basis, which is a manifestation of the underlying supply and demand for each of the currencies involved in the FX swap transaction. For example, if demand for USD is high, investors may be willing to accept a rate of return lower than the current interest rate level being offered in the market.
Changes in this cross-currency basis can be frequent and large, which makes the investment decision difficult without continually polling dealers for an RFQ on an FX swap trade. CME FX Swap Rate Monitor allows real-time market FX swap levels to be displayed in both a deconstructed manage (showing the underlying spot rate and forward rate) and as the implied rate of return from these inputs.
By using an FX swap, an investor can earn any available cross-currency basis spread, and that spread can serve to act as a ‘yield enhancement’ on top of the returns generated by the non-domestic asset that was purchased. In this context, a US asset manager might be better served by converting their USD to EUR, using the EUR to purchase a negative yielding EUR asset, and then converting the EUR back to USD on sale of the asset.
The price risk of the bonds has been ignored for the purposes of this example, but is another dynamic that would also need to be considered by investors.
Learn more about the FX Swap Rate Monitor here.
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