Random Walks in Fixed Income and Foreign Exchange: Unexpected Discoveries in Issuance, Investment and Hedging of Yield Curve Instruments PDF
Preview Random Walks in Fixed Income and Foreign Exchange: Unexpected Discoveries in Issuance, Investment and Hedging of Yield Curve Instruments
JessicaJames,MichaelLeister,andChristophRieger RandomWalksinFixedIncomeandForeignExchange The Moorad Choudhry Global Banking Series Series Editor Professor Moorad Choudhry Jessica James, Michael Leister, and Christoph Rieger Random Walks in Fixed Income and Foreign Exchange Unexpected Discoveries in Issuance, Investment and Hedging of Yield Curve Instruments Theviews,thoughtsandopinionsexpressedinthisbookrepresentthoseoftheauthorsintheir individualprivatecapacities,andshouldnotinanywaybeattributedtoanyemployinginstitution, ortotheauthorsasadirector,representative,officer,oremployeeofanyaffiliatedinstitution. Whileeveryattemptismadetoensureaccuracy,theauthorsorthepublisherwillnotacceptany liabilityforanyerrorsoromissionsherein.Thisbookdoesnotconstituteinvestmentadviceandits contentsshouldnotbeconstruedassuch.Anyopinionexpresseddoesnotconstitutea recommendationforactiontoanyreader.Thecontentsshouldnotbeconsideredasa recommendationtodealinanyfinancialmarketorinstrumentandtheauthors,thepublisher,the editor,anynamedentity,affiliatedbodyoracademicinstitutionwillnotacceptliabilityforthe impactofanyactionsarisingfromareadingofanymaterialinthisbook. ISBN978-3-11-068868-9 E-ISBN(PDF)978-3-11-068873-3 E-ISBN(EPUB)978-3-11-068879-5 ISSN2627-8847 LibraryofCongressControlNumber:2021933285 BibliographicinformationpublishedbytheDeutscheNationalbibliothek TheDeutscheNationalbibliothekliststhispublicationintheDeutscheNationalbibliografie; detailedbibliographicdataareavailableontheInternetathttp://dnb.dnb.de. ©2021WalterdeGruyterGmbH,Berlin/Boston Coverimage:Nikada/E+/GettyImages Typesetting:IntegraSoftwareServicesPvt.Ltd. Printingandbinding:CPIbooksGmbH,Leck www.degruyter.com Advance Praise for Random Walks in Fixed Income and Foreign Exchange Thiscollectionisbeautifullywrittenbypractitionersattheforefrontof“actuallyuseful research”.Ihighlyrecommenditforenhancingknowledgeofthecross-currencybasis, howtohedgefixedincomesecuritiesandunderstandingyield-curvebehaviourinthe low-interestworld...allkeytosuccessfulemploymentastheglobaleconomytrans- formsthroughtheconduitoffinancialmarkets. ProfessorCarolAlexander ProfessorofFinance,UniversityofSussex Thisbookcoverssomeimportantmaterialinawaythatmakesitaccessibletoawide rangeofpractitionersandacademics.Thefirstpartofthebooklooksatthecross-cur- rency basis. It explains why it has existed since 2008 and discusses whether traders canprofitfromit.Thesecondpartofthebookconsiderstheimpactoflowinterestrates on the way we should analyze yield curves. It carefully considers the term premium, duration,andconvexity.Thewholebookisa“must-read”foreveryoneconcernedwith FXorfixedincomemarkets. JohnHull MapleFinancialProfessorofDerivativesandRiskManagement, JosephL.RotmanSchoolofManagement,UniversityofToronto Random Walks in Fixed Income and Foreign Exchange reminds us that while there arefundamentalprinciplesoffinance,nothinginthefieldstaysthesame.Markets evolveconstantly,withchangesinonequicklyripplingthroughtoothers.Butthat doesn’tmeantherelationshipbetweenassetsstaysthesame.Allthismakesfornew risks,andnewopportunities.Thisbookdoesagreatjobinhelpingyouunderstand thelatestmarketfactorsandrelationships. PeterEisenehardt SecretaryGeneral,InternationalCouncilofSecuritiesAssociations,London, andFacultyMember,TheBTRM https://doi.org/10.1515/9783110688733-202 Foreword Itissometimessaid,notleastbyme,thatthereappearstobesomethingofadivide betweenacademiaandpracticeinfinanceandbanking.Thosewhopublishinaca- demia on finance topics have little or no experience in banking, and those who practiseinfinanceonlyrarely,ifever,readacademicjournalarticlesonthesubject. Ifthisisindeedthecase,itisapity.That’sbecausebothsideswouldbenefitfrom closerinvolvementwiththeother:academicsfromfocusingtheirresearchonareas of direct relevance to practitioners, who would be interested to read practical rec- ommendations on how they should direct their operations; and practitioners, by being able to apply an academic rigour to their analysis and drawing of conclu- sions.Thus,anyactivitythatresultsinbothsidescomingclosertogetherisaposi- tivedevelopmentforsociety. Thisbookreducesslightlythelevel ofclearbluewater betweenacademiaand practiceinfinance.ButbeforeIexpoundonitsmanyvirtues,Imustdeclareanin- terest.Oneoftheauthorsisapersonalfriendofmine,butIwasawareofProfessor JamesandthequalityofherworkmanyyearsbeforeImether,asIwasabigfanof herco-authoredbookInterestRateModelling(JohnWiley&SonsLtd)whichIpur- chasedover20yearsago.Istillhavethatverywell-thumbedcopy.Itisanexcellent read. But then again yield curves and yield curve analysis was my first love in fi- nanceandbanking,soperhapsIwaspre-disposedtobeappreciativeofabookwith suchatitle?Notabitofit.Thistopicisoneofthemostwell-researchedsubjectsin finance-relatedacademia,butfrommyownpersonalobservationsIwouldsuggest that over 80% of the output in this space has virtually zero practical relevance for the employee of a bank. What made Jessica’s book stand out was its accessibility andgenuinevalueforthepractitioner. AndthisisexactlywhatstandsoutinthislatestofferingfromProfessorJames and her co-authors Michael Leister and Christoph Rieger. It helps to bridge the di- videbetweenacademiaandpractice,andtheresultisagenuinelyworthwhileaddi- tiontothefinancialeconomicsliterature. The Foreign Exchange (FX) markets are a multi-trillion dollar vital segment of the global economy, and the basics of it are generally well understood – there is, afterall,alargenumberofpublicationsandwebsitesinthisspace.Butforcorporate entitiesusingFXmarketsforhedging,andthatcoversverymanyentitiesaroundthe world, there are aspects of the market that are less well understood, such as the cross-currency“basis”.Bankswhoprovidetheseproductstotheircorporatecustom- ersalsowillwanttoknowaboutsomeofthemorearcaneaspectsofthemarket.This book addressesthese issues with elan. Anothertechnical topic thatispresented ac- cessiblywithaminimumofmathematics(weareadherentstothelateProfessorSte- phen Hawking’s dictum that for each equation in a book, the readership is cut by one-half!)istheFXconversionfactor,somethingthatcanbeofmaterialsignificance tothoseissuingorinvestinginanon-domesticcurrency. https://doi.org/10.1515/9783110688733-203 VIII Foreword The authors cover these subjects with exceptional clarity and precision in this book.Theyalsodiscussatlengththatmostfavouritetopicofmine,theyieldcurve andthetermpremium.Thetermpremiumisanaspectofyieldcurveanalysisthat is,again,notaswellunderstoodbypractitionersasitshouldbe.Theywillbenefit immediatelyfromareadingoftherelevantchaptersherein. I can honestly say that I am more excited about this book than I have been aboutanyotherfinancialmarketstextsIhavecomeacrossinalongtime.Itisgreat toseeaworkthathasvalueforboththeacademicandthepractitioner,fromwriters whoareclearlyatthetopoftheirgame.Idohopeyouenjoyreadingit. ProfessorMooradChoudhry Surrey,England 31January2021 Contents Foreword VII Preface XIII Chapter1 WhatReallyistheCross-CurrencyBasis? 1 TheCalculationUnderlyingtheCross-CurrencyBasisSwap 1 AQuickNoteonTerminology 1 PerhapstheSimplestFormulainFinancialMathematics 2 HowtheCalculationDistortsNo-ArbitragePricing 3 On29thDecember2011 5 So,WhatActuallyisa‘Cross-CurrencyBasisSwap’? 6 ConversionFactor 6 WheredoestheCross-CurrencyBasisComefrom? 9 WhatKeepstheBasisSwapfromBeingArbitragedAway? 12 CapitalCostofFXDerivatives 12 CounterpartyRisksandCreditLimits 13 Clearing 13 HorsesforCourses 13 HowCouldanInstitutionMakeMoneyfromtheCross-Currency BasisSwap? 13 Appendix1.A:TheFXCarryTrade 16 Appendix1.B:TheCross-CurrencyToolkit 17 Chapter2 XVAandtheCross-CurrencyBasis 21 XVA–WhatisIt? 21 ABriefSummaryofCounterpartyRisk 21 RiskvsCost 23 CVA–TheFirstHorseintheXVAStable 23 DVA–TheNextCalculation 26 FVA–FundingImpact 27 HowXVACostsCouldAffecttheCross-CurrencyBasis 27 SampleXVACalculationUsingMarketStandardCalculation Approach 28 FundingConstraints 30 DetailonDailyFunding/RolloverProcess 34 HistoricalFundingData 35 TradingthexccyBasis 38 X Contents Chapter3 CalculatingNovelCross-CurrencyBasesandFXHedgedPickups 40 WhatistheFXHedgedPickup? 40 FindingxccyBases 41 CalculatingFXHedgedPickup 47 Appendix3.A:XccyBases 49 Appendix3.B:FXHedgedPickups 55 Chapter4 FXHedgingofFixedIncome–WhatistheBestWay? 62 FXHedgeStrategies 62 Maturity-MatchedHedges 63 ReducingUncertaintytotheMinimumLevelfortheWholeTenor 63 PracticalCalculationofMaturity-MatchedYieldPickup 65 HistoricalResultsforG10Maturity-MatchedYieldPickup 66 RollingHedges 69 TakingaShort-TermView 69 PossibleActionsat‘RollPoint’ 70 HistoricalResultsforG10RollingYieldPickup 71 RollingPickup‘OnePeriodOn’andfortheTenorofthe Instrument 74 TranslationEffect 75 VolatilityBreakdown–WhatisDrivingthePerformance? 76 NumericalExample 79 Chapter5 IntroducingtheConversionFactor 81 TheIssuer’sChoices 81 Tenor 81 CreditSpread 81 Cross-CurrencyBasis 82 ConversionFactor 82 FeesandCharges 82 WhatistheConversionFactor? 82 SimplestPossibleExample–1-YearBond,ZeroBasis,USD Corporate 83 MoreRealistic–UsingtheYieldCurve 84 AnotherWaytoThinkaboutIt 84 ExamplesofConversionFactors 87 ForecastingConversionFactors 87 TranslatingSpreadsacrossCurrencies 92
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