Foreign currency basis spreads

Foreign currency basis spreads is about one of the other changes from IAS 39 to IFRS 9 in respect of hedge accounting

What is the cross currency basis spread

In general, the cross currency basis is a measure of dollar shortage in the market. The more negative the basis becomes, the more severe the shortage. For dollar-funded investors, negative basis can work in their favour when they hedge currency exposures. In order to hedge foreign currency exposure, the dollar-funded investors lend out dollar today and receive it back in the future, earning additional cross currency basis spread on top of the yield of their foreign investments. Foreign currency basis spreads

In fact, for years the Reserve Bank of Australia has been swapping its other foreign currency reserves against the Japanese Yen in order to enhance returns. After taking the basis into account, negative yielding short-term Japanese government bonds actually yield higher than many short-term government bonds in other currencies.

For foreign investors, however, the basis could increase their hedging cost of investing in the dollar assets. In order to hedge dollar exposure, foreign investors borrow dollar today and return it back in the future. The basis is the additional hedging cost added to the interest differential of the two currencies. Foreign currency basis spreads

Cross currency basis is an important part of currency management in a global portfolio. Foreign currency basis spreads

Cross-currency swaps are an over-the-counter (OTC) derivative in a form of an agreement between two parties to exchange interest payments and principal denominated in two different currencies. In a cross-currency swap, interest payments and principal in one currency are exchanged for principal and interest payments in a different currency. Interest payments are exchanged at fixed intervals during the life of the agreement. Cross-currency swaps are highly customizable and can include variable, fixed interest rates, or both.

Since the two parties are swapping amounts of money, the cross-currency swap is not required to be shown on a company’s balance sheet. Foreign currency basis spreads

Changes from IAS 39 to IFRS 9

IFRS 9 also introduces a new accounting treatment for currency basis spreads. The currency basis spread, a phenomenon that became very significant during the financial crisis, is a charge embedded in financial instruments that compensates for aspects such as country and liquidity risk. This charge only applies to transactions involving the exchange of foreign currencies at a future point in time (as, for example, in currency forward contracts or CCIRS).

Historically, the difference between the spot and forward prices of currency forward contracts and CCIRS represented the differential between the interest rates of the two currencies involved. However, basis spreads increased significantly during the financial crisis and with the following sovereign debt crisis, and have become a significant and volatile component of the pricing of longer term forward contracts and CCIRS. Foreign currency basis spreads

Foreign currency basis spreads

The standard cites currency basis spread as an example of an element that is only present in the hedging instrument, but not in a hedged item that is a single currency instrument. Consequently, this would result in some ineffectiveness even when using a hypothetical derivative for measuring ineffectiveness (see ‘Hypothetical derivatives for measuring ineffectiveness‘).

When using a foreign currency forward contract or a CCIRS in a hedge, the currency basis spread is an unavoidable ‘cost’ of the hedging instrument. During its redeliberations leading to the published final standard, the Board decided that currency basis spreads are a ‘cost of hedging’. The cost of a hedging activity should be recognised in profit or loss at the same time as the hedged transaction.

Consequently, the Board decided to expand the requirements regarding the accounting for costs of hedging to also include currency basis spreads in a way similar to the forward element of forward contracts. This means that, when designating a hedging instrument, an entity can exclude the currency basis spread and account for it separately in the same way as the accounting for the forward element of the forward rate, as described in ‘General requirements‘. However, if an entity designates the entire hedging instrument, fair value changes due to changes in the currency basis spread would result in some ineffectiveness.

Foreign currency basis spreads

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