Currency Basis Swap Valuation : Theory & Practise

Abstract: Banks finance their operations in several ways, by shareholders equity, receiving deposits from customers and by borrowing from investors and other financial institutions. One widely used approach is to issue a bond. Bonds issued on the foreign capital markets is a way to increase the financing options and mitigate risk exposure. When a bank converts foreign capital to domestic capital, there is a degree of currency risk involved. One commonly used instrument for converting capital from one currency to another is a cross currency swap. Since the Global Financial Crisis 2007-2009 regulations imposed by regulators have increased. Banks are required to have sound risk management practises where risk exposure is estimated. In response to recent regulations banks have several departments which assess and follow up risks taken in the operations. As a result, at least two systems are used when valuing financial instruments, one where all trades are conducted, the front office system, and one where risk exposure is estimated, the risk system. The aim of this project is to investigate why there is a discrepancy between the two systems. We will also analyse how this discrepancy affects risk measures. By replicating the two systems’ valuation it is possible to distinguish why there is a discrep- ancy between the systems, regarding the valuation of cross currency basis swaps. When the replication is in place, risk measure calculations are conducted to enable analysis of the impact on risk measures. There are two main differences found between the two systems and how they value a cross currency basis swap: (i) how the underlying risk factors are used; and (ii) how an upcoming cash flow is settled. The effect of these discrepancies are that the risk system overestimate the risk exposure compared with the front office system.