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Cross-Currency and FX Swaps A Structural Analysis

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Cross-Currency and FX Swaps A Structural Analysis
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Nilesh Kukreja
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Cross-Currency and FX Swaps A Structural Analysis - June 8th, 2008

.










Table of Contents
1. Abstract………………………………………………………….…...4
2. Introduction…………………………………………………....…….5
3. What are currency swaps? .................................................. .............8
4. Rules for inter-bank market………………………………..………8
5. Basic schemes of cross currency basic swap……………….……....9
6. Cross currency swap mechanics…………………………….……10
7. Fx swap………………………..………………………………..…...11
8. No arbitrage conditions between currency swap market………..12
9. Fixed vs. floating cross currency swaps……………………….….14
10. Pricing and valuation……………………………………………....15
11. Using a cross currency swap to transform loans and assets….....16
12. Creating assets/ liability currency matches…………………...….16
13. Minimizing interest costs and enhancing interest earnings……..19
14. Structural models of price discovery……………………………...20
15. Robustness check: Reduced form analysis…………………….....20
16. Concluding remark……………………………………………...…21
17. Refrences……………………………………………………………22













Abstract:

This paper investigates the relative role of price discovery between two long-term swap contracts that exchange between the U.S. dollar and the Japanese yen: cross-currency basis swap and FX (foreign exchange) swap. First, we show that these two swaps should be in a no-arbitrage relationship by allowing for differential risk premiums. Second, we empirically investigate the relative role of price discovery using the structural-form approach based on the state space models. Main finding are as follows. (i) The efficient prices extracted as a common factor of the two swaps show a very similar movement, regardless of model specifications. (ii) The currency swap market plays a much more
dominant role in price discovery than the FX swap market. (iii) The FX swap prices tend to under-react to the efficient price changes, while the cross-currency swap prices almost exactly react to them.











Introduction
This paper investigates the relative role of price discovery between two long-term swap contracts that exchange between the U.S. dollar (USD) and the Japanese yen: cross-currency swap and foreign exchange (FX) swap contracts. To that end, we use the structural-form approach based on the state space models. Cross-currency and FX swap markets have been important markets for raising foreign currencies with terms longer than one year for both Japanese and non-Japanese banks. Although the scheme is somewhat different, they have the same economic function as exchanging between the USD and the yen.1 Historically, liquidity of the long-term FX swap market had been very low, compared with the cross-currency swap market, and hence most of the studies have used only the cross-currency swap prices to test the long-term covered interest parity thus far. Recently, however, market participants argue that liquidity of the long-term FX swap market has improved substantially, and there are a number of active arbitragers who attempt to take profits when prices deviate each other. Hence, in this paper, we attempt to assess the relative role of price discovery between these two swap markets by extracting the efficient price that is common to both markets. More specifically, we proceed by taking the following steps.
First, we show that the cross-currency swap and the FX swap should be in a no-arbitrage
relationship by allowing for differential risk premiums. The literature uses cross-currency swap prices to test the long-term interest rate parity, ignoring the differential risk premiums between counterparties, as well as between currencies.2 This simplification seems to have been relevant prior to the middle of the late 1990s. Since the late 1990s, however, the creditworthiness of Japanese banks deteriorated so much, due mainly to the non-performing loan problem, that they were obliged to pay the so-called Japan premiums on a global basis.3 The Japan premiums were observed not only in the short-term money markets, but also in the longer-term markets until recently, as shown by Baba et al. [2006].4 We also have consistently observed non-negligible time-varying differential risk premiums for both Japanese and non-Japanese banks between the USD and the yen markets. In fact, as shown in section 2, we cannot explain the real-life price movement of cross-currency swap and FX swap without allowing for such differential risk premiums.
Second, given that both swap prices should be in a no-arbitrage condition, we investigate
the relative role of price discovery between the cross-currency swap and FX swap markets. Empirical methodologies to test price discovery have progressed significantly in the past decade or so. First, Gonzalo and Granger [1995] and Hasbrouck [1995] proposed a price discovery measure, respectively, based on the vector error correction model (VECM). We call this type of methodology a reduced-form approach. On the other hand, Menkveld, Koopman, and Lucas [2007] recently opened up the way to model the unobserved efficient price common to cross-listed stocks using a state space model, and successfully gauged the relative role of price discovery between the two markets under study. We call this type of methodology a structural-form approach following Harvey [1989].5 These two approaches have merits and demerits, respectively. The reduced-form
approach places fewer ad hoc restrictions on the data than the structural-form approach. In terms of the interpretability of estimation results, however, the structural-form approach is more straightforward than the reduced-form approach. The structural-form approach can also be used more effectively and easily for various hypothesis-testing including the partial vs. complete adjustment of market prices to the efficient price and under/overreaction of market prices to the efficient price. In this paper, we use the structural-form approach due mainly to the effectiveness and easiness of such hypothesis-testing and higher interpretability. But, taking the above-mentioned merits and demerits into account, we also use the more conventional reduced-form approach to check robustness of the estimation results from the structural approach.








What are currency swaps?
A currency swap is an agreement between two parties to buy or sell currency (generally) at spot rates, which reverts at the end of an agreed period for a specified price (the forward rate). Such agreements actually involve a double contract, i.e. a spot rate currency trade and a currency forward agreement.
Rules for the inter-bank market:
The inter-bank currency swap market is governed by Rules no. 187 issued on March 8, 2002. Trading in the market is confined to a single type of swap, currency swaps, where the principal changes hands at the start of the agreement and on its completion. Market makers in the inter-bank foreign exchange market are entitled to belong to the currency swap market. The Central Bank may also trade there, but is not obliged to even if requested to do so. Participants in the interbank markets for foreign exchange and currency swaps are Búnadarbanki, Íslandsbanki, Kaupthing Bank and Landsbanki. Trading in the market is conducted in Icelandic krónur and US dollars, and participants are obliged to quote binding buying and selling rates for the US dollar, if requested by any other participant, for eight periods. The reference amount is US$ 3 million, but participants are free to negotiate other sums. Periods are one week (S/W), 2 weeks (T/W), one month (1 M), 2 months (2 M), 3 months (3 M), 6 months (6 M), 9 months (9 M) and one year (12 M). Participants may negotiate other periods among themselves. For each period, the maximum interest rate spread shall be 25 basis points. Bids shall be updated at intervals of no less than 5 minutes and published on a separate page in the Reuters information system to which market participants have sole access. Trading may take place from 9:30 to 14:00 every business day. A market participant who has quoted a
rate which results in a trade shall notify the Central Bank, stating the amount in US dollars, the length, spot rate and forward points (premium on the spot

Basic Schemes of Cross-Currency Basis Swap and FX Swap:
Cross-Currency Basis Swap
There are numerous types of cross-currency swap contracts, among which the most widely used is the following type of contracts named the cross-currency basis swap.6 A typical cross-currency basis swap (currency swap, hereafter) agreement is a contract in which Japanese banks borrow USD from, and lend yen to non-Japanese banks simultaneously. Figure 1 (i) illustrates the flow of funds associated with this currency swap. At the start of the contract, bank A (a Japanese bank) borrows X USD from, and lends X × S yen, to bank B (a non-Japanese bank), where S is the FX spot rate. During the contract term, bank A receives yen-LIBOR 3M+α from, and pays USD-LIBOR 3M,
to bank B, every 3 months.7 When the contract expires, bank A returns X USD to bank B, and bank B returns X × S yen to bank A. At the start of the contract, both banks decide α , which is the price of the basis swap. In other words, bank A (B) borrows foreign currency by putting up its home currency as collateral, and hence this swap is effectively a collateralized contract. These currency swaps have been employed by both Japanese and non-Japanese banks to fund foreign currencies, both for their own and their customers, including multinational corporations engaged in foreign direct investment. Currency swaps have been also used as a hedging tool, particularly for issuers of the so-called Samurai bonds, which are yen-denominated bonds issued in Japan by non-Japanese companies. By nature of these transactions, most of them are long-term from one year to 30 years.
Cross Currency Swap Mechanics
Cross currency swaps are agreements between counterparties to exchange interest and principal payments in different currencies. To understand the mechanics of a cross currency swap, it is helpful to begin with the simplest derivative in the foreign exchange market, the forward contract. A FX forward involves the exchange of one currency for another, on a future date and at a forward price established today. The forward price can be viewed as the sum of the spot rate and the forward points, which indicate the relative premium or discount of the future transaction based on the interest rates of the currencies. As such, a forward transaction can be said to be comprised of two components—an exchange of principal and an exchange of interest payments – both of which occur at expiry. The principal exchange is based on today’s spot rate; the interest payments—depending on the yields for the tenor of the contract—are determined at the beginning and paid in a lump sum along with the principal. The ratio of the total currency amounts exchanged at expiry is the forward price. Like a forward, a cross currency swap consists of the exchange of principal amounts (based on today’s spot rate) and interest payments between counterparties. Unlike a forward, however, a cross currency swap involves multiple exchanges of interest (and even principal amounts). The CCS for instance, involves periodic exchanges of interest over the life of the swap (rather than a single exchange of interest at expiry as in a fx forward), as well as the exchange of principal at maturity. Often, the counterparties will exchange principal initially as well, although this exchange is optional. With the initial exchange, the cross currency swap is akin to a FX swap with spot and forward legs
FX Swap
A typical FX swap agreement is also a contract in which Japanese banks borrow USD from, and lend yen to non-Japanese banks simultaneously.8 The main differences from the currency swap are that (i) during the contract term, there are no exchanges of interest between yen and USD rates; and (ii) at the end of the contract, the different amount of funds are returned from the amount exchanged at the start. At the start of the contract, bank A (Japanese bank) borrows X USD from, and lends X × S yen, to bank B (non-Japanese bank), where S is the FX spot rate. When the contract expires, bank A returns X
USD to bank B, and bank B returns X × F yen to bank A, where F is the FX forward rate as of the start of the contract. As is the case with currency swaps, FX swaps are effectively collateralized contracts. FX swaps have been employed by both Japanese and non-Japanese banks for funding foreign currencies, both for their own and their customers, including exporters and importers, as well as Japanese institutional investors investing in hedged foreign bonds. FX swaps have also been used as a tool for speculative trading. The most liquid term is shorter than one year, but transactions with longer maturities have been actively conducted from such motives as foreign currency funding for corporate direct investments and arbitrage activities with cross-currency currency swaps. In fact, many market participants point out that liquidity of the FX swaps with maturities longer than one year has improved during the past several years.


No-Arbitrage Conditions between Currency Swap and FX Swap Markets:
Basis Setup
In this section, we construct the no-arbitrage condition between currency swap and FX swap markets. The literature uses only currency swap prices to test the long-term covered interest parity, ignoring the differential risk premiums between lenders and borrowers, as well as between currencies, although some noticed its potential importance. Here, we notice substantial differences in the risk premiums between Japanese and non-Japanese banks in the same currency market, as well as between the USD and the yen markets for the same bank group. The differential risk premiums between Japanese and non-Japanese banks have been usually explained by the so-called Japan premium story. Since the late 1990s, deterioration in creditworthiness of Japanese banks relative to other advanced nations’ banks has significantly influenced their foreign currency funding, particularly USD funding. The deterioration of creditworthiness was originally caused by the non-performing loan problem triggered by the bursting of the asset bubbles in the early 1990s.
More puzzling is the larger and more persistent differential risk premiums between the
USD and the yen markets for the same bank group. Figure 2 shows that risk premiums are much higher in the USD market than in the yen market for both Japanese and non-Japanese banks and fluctuate widely over time. Market participants often cite a difference in main participants and hence in attitudes toward risk evaluation as its main reason.12 Aside from the reasons, there surely exist the non-negligible differential risk premiums, particularly between the USD and the yen market for the same bank group, and hence in this paper, we explicitly allow for such differential risk premiums to construct the no-arbitrage conditions linking the currency and FX swap market. Specifically, we start by describing the typical funding structure of Japanese and non-Japanese banks, following Nishioka and Baba [2004]. The funding costs in the yen and USD markets are the sum of the risk-free interest rate and the risk premium for the representative Japanese or non-Japanese bank in each market. Let rjpy ( rusd ) denote the yen (the USD) risk-free interest rate, φ jpy (φ usd ) the risk premium for the Japanese bank in the yen (USD) market, and θ jpy (θ usd ) the risk premium for the non-Japanese bank in the yen (USD) market. The main source of risk premiums is credit or default risk of borrowers, but here we expand the notion of risk premiums to involving price movements caused by ex ante supply-demand and liquidity conditions, not limiting to the conventional stationary component.
.











Fixed vs. Floating Cross Currency Swaps
Many companies favor the use of cross-currency swaps because, as over the counter instruments, they are easy to customize. In addition to the frequency of interest exchanges, the reference interest rates used to determine the interest payments can be customized to reflect the specific needs of the user. Although the interest rates must correspond to the currencies involved in the principal exchange, the actual benchmark rates used are up to the parties entering into the swap. This means that companies can match the reference rates for these instruments to those of their specific liabilities/assets, whose interest flows may be tied rates other than, say, LIBOR rates1. Furthermore, these instruments allow the interest rates on either side of the transaction to be fixed or floating rates. For instance, if a company has liabilities with floating interest payments, they can enter into a cross currency swap where they receive the floating interest payments from the counterparty and pay a fixed interest rate in return. Figure 2 illustrates four different
combinations of cross currency swaps for a firm wishing to receive foreign currency flows.








Pricing and Valuation
At inception, the value of a typical, vanilla swap is zero. This implies that the two back-to-back “bonds” (i.e., cash flows in a single currency) being exchanged have equivalent NPVs, when valued in a common currency at the spot exchange rate. Floating-for-floating swaps are akin to a bundle of two floating rate coupon bonds, whereas fix-for-fix swaps are akin to a bundle of two fixed coupon bonds. In terms of quoting convention, whereas the pricing of forwards contracts are expressed in terms of “points,” CCS is expressed in terms of “spreads” to the benchmark rates. After inception, as the two yield curves shift and the spot exchange rate moves, the value of a CCS will tend to change. The swap’s value is determined by revaluing the remaining contractual cash flows on each side of the swap at current market rates (i.e., discounting future flows to determine net present values) and then converting the NPVs to a common currency (the USD) at the current spot rate). The difference between the NPVs of the legs is the current value of the
swap. For a floating-for-floating swap, because the respective-currency NPVs of each side of the swap remain unchanged as yield curves shift, changes in the value of the swap correspond only to changes in the spot exchange rate. For fix-for-fix swaps, since the interest payments are locked-in at initiation, changes in value reflect changes in yields as well as spot rates. As such variable rate structures tend to provide more stable mark-to-market profiles throughout their lives than fix-rate swaps of the same tenor.



Using a Cross Currency Swap to Transform Loans and Assets
Fundamentally, because CCS changes the currency denomination of assets and liabilities, they can be used to alter the expected interest earnings/costs and foreign currency risk associated with those assets and liabilities. For example, suppose that a company has a USD-denominated bond. To reduce its expected borrowing cost (and, for the moment, ignoring risk considerations), the company may wish to access the lower interest rate JPY market. To do this, it can use a CCS to create synthetic JPY-denominated debt. The initial exchange converts the USD bond proceeds to yen, and the subsequent cashflows (i.e., the JPY payments to and USD receipts from the swap counterparty) convert the interest and principal payments from dollars to yen. Similarly, cross-currency swaps can be used to manage FX risk by, say, transforming the currency of an investment. Instead of moving cash physically across borders, swaps can be used as an overlay instrument to transform an asset’s currency denomination synthetically. A company that is currently holding JPY assets, for instance, may have a strong view that JPY will weaken considerably against USD and prefer, therefore, to hold a USD-denominated asset. A CCS involving paying JPY and receiving USD would effectively convert the investment from yen into dollars.


Creating Asset/Liability Currency Matches
Cross currency swaps can also be used strategically to alter, and thereby create more appropriate, currency matches within broad portfolios of assets and liabilities. By using them, companies can adjust the currency denomination of liabilities and cash outflows to match those of assets and cash inflows, creating natural offsets and hedges against currency movements on a strategic and portfolio basis. As a simple example, imagine a company with a foreign-currency denominated funding but operations mostly in the US and cash flows in USD. If the foreign currency strengthens against the USD, the company will be left with a larger liability position and larger USD cash outflows to service the foreign-currency denominated loan. Instead of leaving itself at risk to a strengthening of the foreign currency, however, the company could swap the loan into US dollars. Changes in the value of the swap will provide a perfect offset to changes in the value of
the loan, insulating financial statements from the impact of currency moves. Broadly, the
company has converted a foreign liability to match the land, equipments, and properties on the asset side. And on a cash flow basis, the CCS will leave net interest expenses in the same currency as firm revenues. In practice, many US companies have global operations but a majority of their liabilities denominated in USD2. And as companies continue expanding globally and investing overseas, foreign revenue growth will lead to a widening currency mismatch if funding of that expansion remains largely in USD. Such a currency mismatch would leave the firm exposed to shortfalls in liquidity, should currency values change significantly. To prevent the emergence of such a mismatch, companies in this situation may wish to swap a portion of their USD debt into foreign currencies (those in which long-term revenue growth is considered the most promising). Such synthetic foreign currency debt will provide a natural hedge for growing non-USD assets, and allow foreign revenues to be used to service interest on the borrowings.
Similarly, for companies whose funding is largely USD-based but whose overseas growth will occur via foreign operating entities in their respective markets, a CCS can be an effective tool for funding the foreign operation in its local currency and managing any subsequent intercompany loan. The currency amount received in the initial exchange of the swap can be onlent to the foreign entities. Thereafter, inflows from the swap will mirror those from a USD bond, providing a match to the company’s underlying USD-denominated funding. Concomitantly, outflows due to the swap will mimic those of foreign currency debt. With the swap, the US parent transforms the currency denomination of a share of its liabilities from USD to foreign currency, matching that of its growing overseas assets, while the subsidiary is left with an intercompany liability denominated in the currency of its operations and income.
Designated as such, the swap would protect the USD value of the parent’s foreign equity investment, as well as future cashflows returned from the business (in the form of dividends and royalties)3. Ultimately, to minimize currency risk, firms may desire “to localize” their assets and liabilities, i.e., borrow in the markets where is to be used and assets are to be accumulated. In many circumstances, however, this may not possible or practical. In these cases, companies may find that CCS are an efficient tool for synthetically effecting portfolio adjustments.







Minimizing Interest Costs and Enhancing Interest Earnings
In addition to using CCS to manage FX risk, companies can utilize these flexible and efficient instruments to alter the expected interest costs or earnings of a portfolio. A firm managing a net debt portfolio, for instance, may find it more efficient to use cross currency swaps to transform the funds raised into the ultimate currencies of need, rather than to raise funds directly in the currencies needed. In the current interest rate environment, with USD interest rates higher than many others (such as EUR, CAD, and JPY), a US company raising capital may find it attractive to consider alternative currencies. While interest rate differentials favor direct issuance in currencies other than the USD, similar (and even superior) funding advantages may be achieved by combining issuance in USD with a CCS. Moreover, the latter may allow the issuer to circumvent some of the additional challenges associated with a foreign issuance, such as limited market size and name recognition/investor appetite. Indeed, in some currencies/countries, a cross currency swap may provide the only means of securing long-term, fixed-rate financing (where borrowing needs may be too small or expensive to fund through capital markets, private placements or local bank lines).






Structural Models of Price Discovery
Price discovery is defined by Lehmann [2002] as the efficient and timely incorporation of
information implicit in investor trading into market prices. When the same fundamentals are priced 10 into two markets, order flow is fragmented and price discovery is split between these markets. There are various specifications for structural models. In this paper, we adopt the following three models that are extensively investigated in the literature.


Robustness Check: Reduced-Form Analysis
As an attempt to check robustness of the above estimation results, we also estimate the price discovery measures based on the reduced-form approach. There are two approaches that attracted academic attention in this regard. One is the permanent-transitory (PT) model developed by Gonzalo and Granger [1995], and the other is the information share (IS) model developed by Hasbrouck [1995]. Both models rely on the estimation of the VECM of market prices. The PT model decomposes the common factor itself and attributes superior price discovery to the market that adjusts least to price movements in the other market. On the other hand, the IS model decomposes the variance of the common factor based on the assumption that price volatility reflects new information flows and hence the market that contributes most to the variance of the innovations to the common factor is considered to contribute most to price discovery.


Concluding Remarks
This paper has investigated the relative role of price discovery between two long-term swaps that exchange between the U.S. dollar and the Japanese yen: cross-currency (basis) swap and FX swap. First, we have shown that we should consider differential risk premiums, particularly between the yen and USD markets for the same bank group, to explain the negativity of the prices of .these two swaps using the no-arbitrage argument.
Second, we have empirically investigated the relative role of price discovery using three
structural models. Main findings are as follows. (i) The efficient prices extracted as a common factor of the two swaps show a very similar movement, regardless of model specifications. (ii) The currency swap market plays a much more dominant role in price discovery than the FX swap market. (iii) The FX swap prices tend to under-react to the efficient price changes, while the currency swap prices almost exactly react to them. These results are broadly consistent with perceptions of market participants










References:
Amihud, Y., and H. Mendelson [1987], “Trading Mechanisms and Stock Returns: An Empirical Investigation,” Journal of Finance,
42, pp.1-30.
Baba, N., M. Nakashima, Y. Shigemi, and K. Ueda [2006], “The Bank of Japan’s Monetary Policy and Bank Risk Premiums in the Money Market,” International Journal of Central Banking,
2, pp.105-135.
Baillie, R., G. Booth, Y. Tse, and T. Zabotina [2002], “Price Discovery and Common Factor Models,” Journal of Financial Markets,
5, pp.309-321.
Covrig, V., B. S. Low, and M. Melvin [2004], “A Yen is Not a Yen: TIBOR/LIBOR and the Determinants of the Japan Premium,” Journal of Financial and Quantitative Analysis, 39, pp.193-208.
Durbin, J., and S. J. Koopman [2001], Time Series Analysis by State Space Models, Oxford, Oxford University Press. Engle, R., and C. Granger [1987], “Cointegration and Error-correction Representation, Estimation and Testing,” Econometrica,
55, pp.251-276.
Fletcher, D., and J. Sultan [1997], “Cross Currency Swap Rates and Deviations from Interest Rate Parity,” Journal of Financial Engineering,
6, pp.47-69.
Fletcher, D., and L. W. Taylor [1994], “A Non-parametric Analysis of Covered Interest Parity in Long-date Capital Markets,” Journal of International Money and Finance,
13, pp.459-475.
Fletcher, D., and L. W. Taylor [1996], “Swap Covered Interest Parity in Long-Date Capital Market,” Review of Economics and Statistics,
78, pp.530-538.
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Re: Cross-Currency and FX Swaps A Structural Analysis
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Jitendra Mazee
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Re: Cross-Currency and FX Swaps A Structural Analysis - January 25th, 2018

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Originally Posted by kukrejanilesh View Post
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Table of Contents
1. Abstract………………………………………………………….…...4
2. Introduction…………………………………………………....…….5
3. What are currency swaps? .................................................. .............8
4. Rules for inter-bank market………………………………..………8
5. Basic schemes of cross currency basic swap……………….……....9
6. Cross currency swap mechanics…………………………….……10
7. Fx swap………………………..………………………………..…...11
8. No arbitrage conditions between currency swap market………..12
9. Fixed vs. floating cross currency swaps……………………….….14
10. Pricing and valuation……………………………………………....15
11. Using a cross currency swap to transform loans and assets….....16
12. Creating assets/ liability currency matches…………………...….16
13. Minimizing interest costs and enhancing interest earnings……..19
14. Structural models of price discovery……………………………...20
15. Robustness check: Reduced form analysis…………………….....20
16. Concluding remark……………………………………………...…21
17. Refrences……………………………………………………………22













Abstract:

This paper investigates the relative role of price discovery between two long-term swap contracts that exchange between the U.S. dollar and the Japanese yen: cross-currency basis swap and FX (foreign exchange) swap. First, we show that these two swaps should be in a no-arbitrage relationship by allowing for differential risk premiums. Second, we empirically investigate the relative role of price discovery using the structural-form approach based on the state space models. Main finding are as follows. (i) The efficient prices extracted as a common factor of the two swaps show a very similar movement, regardless of model specifications. (ii) The currency swap market plays a much more
dominant role in price discovery than the FX swap market. (iii) The FX swap prices tend to under-react to the efficient price changes, while the cross-currency swap prices almost exactly react to them.











Introduction
This paper investigates the relative role of price discovery between two long-term swap contracts that exchange between the U.S. dollar (USD) and the Japanese yen: cross-currency swap and foreign exchange (FX) swap contracts. To that end, we use the structural-form approach based on the state space models. Cross-currency and FX swap markets have been important markets for raising foreign currencies with terms longer than one year for both Japanese and non-Japanese banks. Although the scheme is somewhat different, they have the same economic function as exchanging between the USD and the yen.1 Historically, liquidity of the long-term FX swap market had been very low, compared with the cross-currency swap market, and hence most of the studies have used only the cross-currency swap prices to test the long-term covered interest parity thus far. Recently, however, market participants argue that liquidity of the long-term FX swap market has improved substantially, and there are a number of active arbitragers who attempt to take profits when prices deviate each other. Hence, in this paper, we attempt to assess the relative role of price discovery between these two swap markets by extracting the efficient price that is common to both markets. More specifically, we proceed by taking the following steps.
First, we show that the cross-currency swap and the FX swap should be in a no-arbitrage
relationship by allowing for differential risk premiums. The literature uses cross-currency swap prices to test the long-term interest rate parity, ignoring the differential risk premiums between counterparties, as well as between currencies.2 This simplification seems to have been relevant prior to the middle of the late 1990s. Since the late 1990s, however, the creditworthiness of Japanese banks deteriorated so much, due mainly to the non-performing loan problem, that they were obliged to pay the so-called Japan premiums on a global basis.3 The Japan premiums were observed not only in the short-term money markets, but also in the longer-term markets until recently, as shown by Baba et al. [2006].4 We also have consistently observed non-negligible time-varying differential risk premiums for both Japanese and non-Japanese banks between the USD and the yen markets. In fact, as shown in section 2, we cannot explain the real-life price movement of cross-currency swap and FX swap without allowing for such differential risk premiums.
Second, given that both swap prices should be in a no-arbitrage condition, we investigate
the relative role of price discovery between the cross-currency swap and FX swap markets. Empirical methodologies to test price discovery have progressed significantly in the past decade or so. First, Gonzalo and Granger [1995] and Hasbrouck [1995] proposed a price discovery measure, respectively, based on the vector error correction model (VECM). We call this type of methodology a reduced-form approach. On the other hand, Menkveld, Koopman, and Lucas [2007] recently opened up the way to model the unobserved efficient price common to cross-listed stocks using a state space model, and successfully gauged the relative role of price discovery between the two markets under study. We call this type of methodology a structural-form approach following Harvey [1989].5 These two approaches have merits and demerits, respectively. The reduced-form
approach places fewer ad hoc restrictions on the data than the structural-form approach. In terms of the interpretability of estimation results, however, the structural-form approach is more straightforward than the reduced-form approach. The structural-form approach can also be used more effectively and easily for various hypothesis-testing including the partial vs. complete adjustment of market prices to the efficient price and under/overreaction of market prices to the efficient price. In this paper, we use the structural-form approach due mainly to the effectiveness and easiness of such hypothesis-testing and higher interpretability. But, taking the above-mentioned merits and demerits into account, we also use the more conventional reduced-form approach to check robustness of the estimation results from the structural approach.








What are currency swaps?
A currency swap is an agreement between two parties to buy or sell currency (generally) at spot rates, which reverts at the end of an agreed period for a specified price (the forward rate). Such agreements actually involve a double contract, i.e. a spot rate currency trade and a currency forward agreement.
Rules for the inter-bank market:
The inter-bank currency swap market is governed by Rules no. 187 issued on March 8, 2002. Trading in the market is confined to a single type of swap, currency swaps, where the principal changes hands at the start of the agreement and on its completion. Market makers in the inter-bank foreign exchange market are entitled to belong to the currency swap market. The Central Bank may also trade there, but is not obliged to even if requested to do so. Participants in the interbank markets for foreign exchange and currency swaps are Búnadarbanki, Íslandsbanki, Kaupthing Bank and Landsbanki. Trading in the market is conducted in Icelandic krónur and US dollars, and participants are obliged to quote binding buying and selling rates for the US dollar, if requested by any other participant, for eight periods. The reference amount is US$ 3 million, but participants are free to negotiate other sums. Periods are one week (S/W), 2 weeks (T/W), one month (1 M), 2 months (2 M), 3 months (3 M), 6 months (6 M), 9 months (9 M) and one year (12 M). Participants may negotiate other periods among themselves. For each period, the maximum interest rate spread shall be 25 basis points. Bids shall be updated at intervals of no less than 5 minutes and published on a separate page in the Reuters information system to which market participants have sole access. Trading may take place from 9:30 to 14:00 every business day. A market participant who has quoted a
rate which results in a trade shall notify the Central Bank, stating the amount in US dollars, the length, spot rate and forward points (premium on the spot

Basic Schemes of Cross-Currency Basis Swap and FX Swap:
Cross-Currency Basis Swap
There are numerous types of cross-currency swap contracts, among which the most widely used is the following type of contracts named the cross-currency basis swap.6 A typical cross-currency basis swap (currency swap, hereafter) agreement is a contract in which Japanese banks borrow USD from, and lend yen to non-Japanese banks simultaneously. Figure 1 (i) illustrates the flow of funds associated with this currency swap. At the start of the contract, bank A (a Japanese bank) borrows X USD from, and lends X × S yen, to bank B (a non-Japanese bank), where S is the FX spot rate. During the contract term, bank A receives yen-LIBOR 3M+α from, and pays USD-LIBOR 3M,
to bank B, every 3 months.7 When the contract expires, bank A returns X USD to bank B, and bank B returns X × S yen to bank A. At the start of the contract, both banks decide α , which is the price of the basis swap. In other words, bank A (B) borrows foreign currency by putting up its home currency as collateral, and hence this swap is effectively a collateralized contract. These currency swaps have been employed by both Japanese and non-Japanese banks to fund foreign currencies, both for their own and their customers, including multinational corporations engaged in foreign direct investment. Currency swaps have been also used as a hedging tool, particularly for issuers of the so-called Samurai bonds, which are yen-denominated bonds issued in Japan by non-Japanese companies. By nature of these transactions, most of them are long-term from one year to 30 years.
Cross Currency Swap Mechanics
Cross currency swaps are agreements between counterparties to exchange interest and principal payments in different currencies. To understand the mechanics of a cross currency swap, it is helpful to begin with the simplest derivative in the foreign exchange market, the forward contract. A FX forward involves the exchange of one currency for another, on a future date and at a forward price established today. The forward price can be viewed as the sum of the spot rate and the forward points, which indicate the relative premium or discount of the future transaction based on the interest rates of the currencies. As such, a forward transaction can be said to be comprised of two components—an exchange of principal and an exchange of interest payments – both of which occur at expiry. The principal exchange is based on today’s spot rate; the interest payments—depending on the yields for the tenor of the contract—are determined at the beginning and paid in a lump sum along with the principal. The ratio of the total currency amounts exchanged at expiry is the forward price. Like a forward, a cross currency swap consists of the exchange of principal amounts (based on today’s spot rate) and interest payments between counterparties. Unlike a forward, however, a cross currency swap involves multiple exchanges of interest (and even principal amounts). The CCS for instance, involves periodic exchanges of interest over the life of the swap (rather than a single exchange of interest at expiry as in a fx forward), as well as the exchange of principal at maturity. Often, the counterparties will exchange principal initially as well, although this exchange is optional. With the initial exchange, the cross currency swap is akin to a FX swap with spot and forward legs
FX Swap
A typical FX swap agreement is also a contract in which Japanese banks borrow USD from, and lend yen to non-Japanese banks simultaneously.8 The main differences from the currency swap are that (i) during the contract term, there are no exchanges of interest between yen and USD rates; and (ii) at the end of the contract, the different amount of funds are returned from the amount exchanged at the start. At the start of the contract, bank A (Japanese bank) borrows X USD from, and lends X × S yen, to bank B (non-Japanese bank), where S is the FX spot rate. When the contract expires, bank A returns X
USD to bank B, and bank B returns X × F yen to bank A, where F is the FX forward rate as of the start of the contract. As is the case with currency swaps, FX swaps are effectively collateralized contracts. FX swaps have been employed by both Japanese and non-Japanese banks for funding foreign currencies, both for their own and their customers, including exporters and importers, as well as Japanese institutional investors investing in hedged foreign bonds. FX swaps have also been used as a tool for speculative trading. The most liquid term is shorter than one year, but transactions with longer maturities have been actively conducted from such motives as foreign currency funding for corporate direct investments and arbitrage activities with cross-currency currency swaps. In fact, many market participants point out that liquidity of the FX swaps with maturities longer than one year has improved during the past several years.


No-Arbitrage Conditions between Currency Swap and FX Swap Markets:
Basis Setup
In this section, we construct the no-arbitrage condition between currency swap and FX swap markets. The literature uses only currency swap prices to test the long-term covered interest parity, ignoring the differential risk premiums between lenders and borrowers, as well as between currencies, although some noticed its potential importance. Here, we notice substantial differences in the risk premiums between Japanese and non-Japanese banks in the same currency market, as well as between the USD and the yen markets for the same bank group. The differential risk premiums between Japanese and non-Japanese banks have been usually explained by the so-called Japan premium story. Since the late 1990s, deterioration in creditworthiness of Japanese banks relative to other advanced nations’ banks has significantly influenced their foreign currency funding, particularly USD funding. The deterioration of creditworthiness was originally caused by the non-performing loan problem triggered by the bursting of the asset bubbles in the early 1990s.
More puzzling is the larger and more persistent differential risk premiums between the
USD and the yen markets for the same bank group. Figure 2 shows that risk premiums are much higher in the USD market than in the yen market for both Japanese and non-Japanese banks and fluctuate widely over time. Market participants often cite a difference in main participants and hence in attitudes toward risk evaluation as its main reason.12 Aside from the reasons, there surely exist the non-negligible differential risk premiums, particularly between the USD and the yen market for the same bank group, and hence in this paper, we explicitly allow for such differential risk premiums to construct the no-arbitrage conditions linking the currency and FX swap market. Specifically, we start by describing the typical funding structure of Japanese and non-Japanese banks, following Nishioka and Baba [2004]. The funding costs in the yen and USD markets are the sum of the risk-free interest rate and the risk premium for the representative Japanese or non-Japanese bank in each market. Let rjpy ( rusd ) denote the yen (the USD) risk-free interest rate, φ jpy (φ usd ) the risk premium for the Japanese bank in the yen (USD) market, and θ jpy (θ usd ) the risk premium for the non-Japanese bank in the yen (USD) market. The main source of risk premiums is credit or default risk of borrowers, but here we expand the notion of risk premiums to involving price movements caused by ex ante supply-demand and liquidity conditions, not limiting to the conventional stationary component.
.











Fixed vs. Floating Cross Currency Swaps
Many companies favor the use of cross-currency swaps because, as over the counter instruments, they are easy to customize. In addition to the frequency of interest exchanges, the reference interest rates used to determine the interest payments can be customized to reflect the specific needs of the user. Although the interest rates must correspond to the currencies involved in the principal exchange, the actual benchmark rates used are up to the parties entering into the swap. This means that companies can match the reference rates for these instruments to those of their specific liabilities/assets, whose interest flows may be tied rates other than, say, LIBOR rates1. Furthermore, these instruments allow the interest rates on either side of the transaction to be fixed or floating rates. For instance, if a company has liabilities with floating interest payments, they can enter into a cross currency swap where they receive the floating interest payments from the counterparty and pay a fixed interest rate in return. Figure 2 illustrates four different
combinations of cross currency swaps for a firm wishing to receive foreign currency flows.








Pricing and Valuation
At inception, the value of a typical, vanilla swap is zero. This implies that the two back-to-back “bonds” (i.e., cash flows in a single currency) being exchanged have equivalent NPVs, when valued in a common currency at the spot exchange rate. Floating-for-floating swaps are akin to a bundle of two floating rate coupon bonds, whereas fix-for-fix swaps are akin to a bundle of two fixed coupon bonds. In terms of quoting convention, whereas the pricing of forwards contracts are expressed in terms of “points,” CCS is expressed in terms of “spreads” to the benchmark rates. After inception, as the two yield curves shift and the spot exchange rate moves, the value of a CCS will tend to change. The swap’s value is determined by revaluing the remaining contractual cash flows on each side of the swap at current market rates (i.e., discounting future flows to determine net present values) and then converting the NPVs to a common currency (the USD) at the current spot rate). The difference between the NPVs of the legs is the current value of the
swap. For a floating-for-floating swap, because the respective-currency NPVs of each side of the swap remain unchanged as yield curves shift, changes in the value of the swap correspond only to changes in the spot exchange rate. For fix-for-fix swaps, since the interest payments are locked-in at initiation, changes in value reflect changes in yields as well as spot rates. As such variable rate structures tend to provide more stable mark-to-market profiles throughout their lives than fix-rate swaps of the same tenor.



Using a Cross Currency Swap to Transform Loans and Assets
Fundamentally, because CCS changes the currency denomination of assets and liabilities, they can be used to alter the expected interest earnings/costs and foreign currency risk associated with those assets and liabilities. For example, suppose that a company has a USD-denominated bond. To reduce its expected borrowing cost (and, for the moment, ignoring risk considerations), the company may wish to access the lower interest rate JPY market. To do this, it can use a CCS to create synthetic JPY-denominated debt. The initial exchange converts the USD bond proceeds to yen, and the subsequent cashflows (i.e., the JPY payments to and USD receipts from the swap counterparty) convert the interest and principal payments from dollars to yen. Similarly, cross-currency swaps can be used to manage FX risk by, say, transforming the currency of an investment. Instead of moving cash physically across borders, swaps can be used as an overlay instrument to transform an asset’s currency denomination synthetically. A company that is currently holding JPY assets, for instance, may have a strong view that JPY will weaken considerably against USD and prefer, therefore, to hold a USD-denominated asset. A CCS involving paying JPY and receiving USD would effectively convert the investment from yen into dollars.


Creating Asset/Liability Currency Matches
Cross currency swaps can also be used strategically to alter, and thereby create more appropriate, currency matches within broad portfolios of assets and liabilities. By using them, companies can adjust the currency denomination of liabilities and cash outflows to match those of assets and cash inflows, creating natural offsets and hedges against currency movements on a strategic and portfolio basis. As a simple example, imagine a company with a foreign-currency denominated funding but operations mostly in the US and cash flows in USD. If the foreign currency strengthens against the USD, the company will be left with a larger liability position and larger USD cash outflows to service the foreign-currency denominated loan. Instead of leaving itself at risk to a strengthening of the foreign currency, however, the company could swap the loan into US dollars. Changes in the value of the swap will provide a perfect offset to changes in the value of
the loan, insulating financial statements from the impact of currency moves. Broadly, the
company has converted a foreign liability to match the land, equipments, and properties on the asset side. And on a cash flow basis, the CCS will leave net interest expenses in the same currency as firm revenues. In practice, many US companies have global operations but a majority of their liabilities denominated in USD2. And as companies continue expanding globally and investing overseas, foreign revenue growth will lead to a widening currency mismatch if funding of that expansion remains largely in USD. Such a currency mismatch would leave the firm exposed to shortfalls in liquidity, should currency values change significantly. To prevent the emergence of such a mismatch, companies in this situation may wish to swap a portion of their USD debt into foreign currencies (those in which long-term revenue growth is considered the most promising). Such synthetic foreign currency debt will provide a natural hedge for growing non-USD assets, and allow foreign revenues to be used to service interest on the borrowings.
Similarly, for companies whose funding is largely USD-based but whose overseas growth will occur via foreign operating entities in their respective markets, a CCS can be an effective tool for funding the foreign operation in its local currency and managing any subsequent intercompany loan. The currency amount received in the initial exchange of the swap can be onlent to the foreign entities. Thereafter, inflows from the swap will mirror those from a USD bond, providing a match to the company’s underlying USD-denominated funding. Concomitantly, outflows due to the swap will mimic those of foreign currency debt. With the swap, the US parent transforms the currency denomination of a share of its liabilities from USD to foreign currency, matching that of its growing overseas assets, while the subsidiary is left with an intercompany liability denominated in the currency of its operations and income.
Designated as such, the swap would protect the USD value of the parent’s foreign equity investment, as well as future cashflows returned from the business (in the form of dividends and royalties)3. Ultimately, to minimize currency risk, firms may desire “to localize” their assets and liabilities, i.e., borrow in the markets where is to be used and assets are to be accumulated. In many circumstances, however, this may not possible or practical. In these cases, companies may find that CCS are an efficient tool for synthetically effecting portfolio adjustments.







Minimizing Interest Costs and Enhancing Interest Earnings
In addition to using CCS to manage FX risk, companies can utilize these flexible and efficient instruments to alter the expected interest costs or earnings of a portfolio. A firm managing a net debt portfolio, for instance, may find it more efficient to use cross currency swaps to transform the funds raised into the ultimate currencies of need, rather than to raise funds directly in the currencies needed. In the current interest rate environment, with USD interest rates higher than many others (such as EUR, CAD, and JPY), a US company raising capital may find it attractive to consider alternative currencies. While interest rate differentials favor direct issuance in currencies other than the USD, similar (and even superior) funding advantages may be achieved by combining issuance in USD with a CCS. Moreover, the latter may allow the issuer to circumvent some of the additional challenges associated with a foreign issuance, such as limited market size and name recognition/investor appetite. Indeed, in some currencies/countries, a cross currency swap may provide the only means of securing long-term, fixed-rate financing (where borrowing needs may be too small or expensive to fund through capital markets, private placements or local bank lines).






Structural Models of Price Discovery
Price discovery is defined by Lehmann [2002] as the efficient and timely incorporation of
information implicit in investor trading into market prices. When the same fundamentals are priced 10 into two markets, order flow is fragmented and price discovery is split between these markets. There are various specifications for structural models. In this paper, we adopt the following three models that are extensively investigated in the literature.


Robustness Check: Reduced-Form Analysis
As an attempt to check robustness of the above estimation results, we also estimate the price discovery measures based on the reduced-form approach. There are two approaches that attracted academic attention in this regard. One is the permanent-transitory (PT) model developed by Gonzalo and Granger [1995], and the other is the information share (IS) model developed by Hasbrouck [1995]. Both models rely on the estimation of the VECM of market prices. The PT model decomposes the common factor itself and attributes superior price discovery to the market that adjusts least to price movements in the other market. On the other hand, the IS model decomposes the variance of the common factor based on the assumption that price volatility reflects new information flows and hence the market that contributes most to the variance of the innovations to the common factor is considered to contribute most to price discovery.


Concluding Remarks
This paper has investigated the relative role of price discovery between two long-term swaps that exchange between the U.S. dollar and the Japanese yen: cross-currency (basis) swap and FX swap. First, we have shown that we should consider differential risk premiums, particularly between the yen and USD markets for the same bank group, to explain the negativity of the prices of .these two swaps using the no-arbitrage argument.
Second, we have empirically investigated the relative role of price discovery using three
structural models. Main findings are as follows. (i) The efficient prices extracted as a common factor of the two swaps show a very similar movement, regardless of model specifications. (ii) The currency swap market plays a much more dominant role in price discovery than the FX swap market. (iii) The FX swap prices tend to under-react to the efficient price changes, while the currency swap prices almost exactly react to them. These results are broadly consistent with perceptions of market participants










References:
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42, pp.1-30.
Baba, N., M. Nakashima, Y. Shigemi, and K. Ueda [2006], “The Bank of Japan’s Monetary Policy and Bank Risk Premiums in the Money Market,” International Journal of Central Banking,
2, pp.105-135.
Baillie, R., G. Booth, Y. Tse, and T. Zabotina [2002], “Price Discovery and Common Factor Models,” Journal of Financial Markets,
5, pp.309-321.
Covrig, V., B. S. Low, and M. Melvin [2004], “A Yen is Not a Yen: TIBOR/LIBOR and the Determinants of the Japan Premium,” Journal of Financial and Quantitative Analysis, 39, pp.193-208.
Durbin, J., and S. J. Koopman [2001], Time Series Analysis by State Space Models, Oxford, Oxford University Press. Engle, R., and C. Granger [1987], “Cointegration and Error-correction Representation, Estimation and Testing,” Econometrica,
55, pp.251-276.
Fletcher, D., and J. Sultan [1997], “Cross Currency Swap Rates and Deviations from Interest Rate Parity,” Journal of Financial Engineering,
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Fletcher, D., and L. W. Taylor [1994], “A Non-parametric Analysis of Covered Interest Parity in Long-date Capital Markets,” Journal of International Money and Finance,
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