A heuristic pricing and hedging framework for multi-currency fixed income desks

TL;DR

This paper introduces a heuristic framework for multi-currency pricing and hedging in fixed income, accounting for funding and collateral effects, and converging to OIS discounting under certain conditions.

Contribution

It presents a novel heuristic present value approach that incorporates funding and collateral considerations into multi-currency pricing and hedging.

Findings

Framework aligns with OIS discounting when FX forwards match cash and carry arguments.

Provides more funding optionality for uncollateralized operations.

Demonstrates convergence to established methods through a worked example.

Abstract

It is well known that traded foreign exchange forwards and cross currency swaps (CCS) cannot be priced applying overnight cash and carry arguments as they imply absence of funding advantage of one currency to the other. This paper proposes a heuristic present value concept for multi-currency pricing and hedging which allows taking into account the funding and therefore the collateral currency and its pricing impact. For uncollateralized operations, it provides more funding optionality to achieve either cheaper or more connected funding to the hedging instruments. When foreign exchange forwards get aligned with overnight cash and carry arguments, this method naturally converges to the well established OIS discounting where each leg is funded in its own currency. A worked example compares this approach with a benchmark.