Cross-Currency Basis Swaps Referencing Backward-Looking Rates

TL;DR

This paper develops a pricing and hedging framework for cross-currency basis swaps referencing backward-looking risk-free rates like SOFR and AONIA, applicable to collateralized swaps in a multi-curve setting.

Contribution

It introduces a novel approach to price and hedge backward-looking cross-currency basis swaps with collateralization, extending to any two currencies and using interest and currency futures.

Findings

Explicit pricing formulas for collateralized cross-currency basis swaps.

Hedging strategies using interest rate and currency futures.

Applicability to various backward-looking RFRs and currencies.

Abstract

The financial industry has undergone a significant transition from the London Interbank Offered Rates (LIBORs) to Risk Free Rates (RFRs) such as, e.g., the Secured Overnight Financing Rate (SOFR) in the U.S. and the Cash Rate (AONIA) in Australia, as primary benchmark rates for borrowing costs. The paper examines the pricing and hedging method for financial products in a cross-currency framework with the special emphasis on the Compound SOFR vs Average AONIA cross-currency basis swap (CCBS) where both reference rates are backward-looking and the swap is collateralized. While the SOFR and AONIA are used as particular instances of RFRs in a cross-currency basis swap, the proposed approach is able to handle backward-looking rates for any two currencies. We give explicit pricing and hedging results for a constant notional cross-currency basis swap with either domestic or foreign collateralization using interest rate futures and currency futures as hedging instruments within an arbitrage-free cross-currency multi-curve setting.