Table Of ContentJessicaJames,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
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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
