Financing Products

Master Chapter Three

Financing Products

We are about to navigate back and forth between cash and derivatives and their mix to discuss some popularly talked about financing solutions in the fixed income world. Let’s start with the basics:

1. Cost of Funding

The value of any financial asset or liability depends on its expected future cash flows, present value of which is obtained by discounting it at a rate commensurate with the risk of the asset or liability. This discount rate is interchangeable with the internal rate of return or the expected return on that funding over a specified tenor.

If you had to link the risk profile of an asset or a business with its expected return – higher risk warrants a higher return over the risk free rate – this return would determine the marginal cost of funding today or to be more nuanced the present enterprise value for a business.

Higher the risk of the funding instrument greater is the return expectation and so funding mix for any business would depend on its risk profile. For instance, Banks would have a lot more debt as a proportion of its total financing given their ability to lever up on the equity capital (equity is the riskiest/most expensive funding instrument) versus private non-financial corporates, that means a lower average cost of funding for banks vs the non-bank sector.

2. Secured and Unsecured Funding

Simply put unsecured funding is funding to an entity without prejudice to any of their owned assets while secured funding is what is backed by a defined charge on the assets (exclusive or not). In addition, secured funding may or may not have recourse to the entity/borrower of funds – common example being a collateralised loans portfolio of a bank that has recourse to the loans but not to the bank.

For the sake of restricting the content to collateralised credit instruments (for now) let’s focus on secured funding products:

Repurchase agreements (Repo) – Is a mode of financing against underlying assets with a promise to return the underlying at the end of the borrowing term at a fixed price. Most common example is a repo against a sovereign bond that’s generally priced as a non-recourse borrowing since risk of the underlying will most times be superior to the credit risk of the borrower. Cost of this financing or the repo rate is a function of the risk of the underlying (being repo-ed) and its relative demand/supply.

Connecting the dots. FX swaps are also a form of repo financing i.e. collateralised exchange of cash in different currencies, implied yield on which is determined by the relative interest rates.

Pricing of a Repo Agreement

• Repos can be understood as short term financing collateralised by assets (legal title transfer) hence its pricing tracks money market yields. Percentage notional of cash lent against an asset (also called Loan to Value, LTV) is a function of the asset’s risk profile/volatility and the tenor of funding. Terms like margin and haircut are also used to reflect the LTV amount, but to importantly assess the overcollateralization of the loan it’s key to understand the difference between the terms. For instance, an 80% LTV which means $80 lent against equity value of $100 – denotes a haircut of 20% (on the value of the equity being repo-ed) but a margin or over-collateralisation of 25% (i.e. 20%/80%) on the cash lent.

• Pricing generally assumes no recourse to the borrower i.e. margin is largely a function of the underlying security/bond being repo-ed.

• Actual funding rate is implied by the difference between the purchase price of the asset (lender of funds) and its sale price on maturity when the repo transaction reverses. Effectively it’s the holding period return for the lender of cash/holder of the collateral security.

• Arbitrage can be created if the repo funding rate differs from the underlying asset’s yield curve for eg. if a 3m repo rate on a 3m Treasury bill is at a rate lower than the 3 month bill’s yield it would create an arbitrage for an investor to borrow funds at repo and invest it in the bill. For the lender of the funds the recourse (full ownership) is only to the T-bill, hence even in case of a default the investor who has funded the bill with repo doesn’t run any risk i.e. his pay-off is either positive or nothing. Conversely if the repo yield is higher than the treasury bill yield it wouldn’t make sense for the investor to finance it on repo as he could generate the funding cheaper by selling the asset itself.

Risk on a repo transaction

Two types of risks to think about:

• Market risk – It’s worth noting that Market traded repo rates are general fixed rates (even though one can structure bespoke repos on floating rate) i.e. fixed at the time of entering the contract. Thus, movement in money market yields or the repo rates i.e. change to the refinancing cost during the repo contract has interest rate (mark to market) risk like any fixed rate instrument.

• Credit Risk – Is the risk (as priced in the margin) of default of the underlying asset assuming no recourse to the borrower as mentioned above. To mitigate credit risk, terms of the contract can be reset if credit risk worsens and the price of the underlying drops below key triggers.

Comparison between ‘Standard’ Market Repos and Securities Lending/Borrowing (can be used interchangeably with Collateralised Lending/Borrowing)

Table 1.

Source: Pandemonium.

Other considerations for repo pricing:

• Initial Margin – Is the overcollateralization of the underlying as a percentage of the loan value. Generally market repo on sovereign bonds does not have daily top-ups (or daily margining) based on the price movement of the underlying hence the margin charged at the beginning of the contract needs to account for the underlying asset price volatility and or credit risk. You can say it’s similar to the initial margin on a bilateral interest rate swap. For example a 3 month repo on an IG (Investment Grade) rated Government bond and an IG rated Corporate Bond may have the same repo rate but a vastly different margins; 3-5% for sovereigns and 15-25% for IG Bonds. A higher Margin amount would therefore imply a higher effective total cost of funding which in most cases would be above the repo rate.

• Title transfer and its implication on pricing – At the start of the repo trade the borrower of the security (repo purchaser) gets the legal ownership of the security i.e. claims all intermediate cash flows on it. But it is important to note they do not get the price risk on it – mark to market swings on the security do not belong to the repo purchaser. When we think about the repo rate cash flows being charged on the lent amount against the security it would be adjusted for all intermediate cash flows on it and for any discount/premium (to the general collateral repo rate) depending on the relative demand/supply of the security.

Trivia. Korea happens to be an exception in the region where despite the title transfer the intermediate bond cash flows belong to the original holder of the bond. The KRX Clearing House redirects the coupon cash flows to the ultimate beneficial owner of the bond. Hence repo rate is a funding rate payable on the cash borrowed instead of being implied in the sale and repurchase price of the underlying bond.

• Availability of comparable instrument/Liquidity of the underlying – Repo cost would importantly be affected by availability of the asset that one wants to borrow and or the specific tenor (often odd dated/customised) for lending cash.

• Accounting requirements – Higher quality assets that form part of regulatory ratios (mandatory Statutory Liquidity Ratio, High Quality Liquid Asset buying) of financial institutions have a higher refinancing value; recall repo/reverse repo on sovereign bonds/bills. Need for such assets let’s say for HQLA and LCR (Liquidity coverage ratio) requirements of banks around certain times of the year impact repo pricing as well especially if one wishes to temporarily borrow without taking market risk of the underlying. This pushes repo rates on them below market/General Collateral rates.

• Special on repo – An excessive demand to borrow a bond owing to a massive short position on it can push the repo rate significantly below the general collateral (GC) market repo rate. In such cases the bond is termed as trading ‘Special-on-Repo’ and the borrower needs to pay carry to be able to maintain the short position. As an example: a 10 year bond trading special on repo at -3% annualised while GC trading at +3% is deemed to have negative carry of 6% implying a loss of 50bps per month to run a short position on the bond.

Securities Lending/Borrowing - For the sake of completion

(For the sake of completion and not repetition I’ll cover this product in its most primitive format) – is a one sided borrowing/lending of securities without any exchange of cash; the table earlier is an updated description of the product as it trades today. The security borrower can use the borrowed security to either short the same or repo with another counterparty to generate cash. The security lender gets an additional spread over and above the current market yield to compensate them for the unsecured credit exposure of the securities borrower. Hence these (uncollateralised) trades were restricted to only financial intermediaries that have very sound credit.

Pricing of securities borrowing/lending

Given the unsecured credit risk of this instrument the security borrower’s unsecured funding cost effectively works as a guide for pricing along with the repo rate of the underlying security. In case the security goes special in repo, the lending spread (to reflect the unsecured risk) over the security’s repo yield should increase. To sum up then – the opportunity cost of lending the security would be akin to repoing it and investing the cash generated into the unsecured loan of the borrower.

Given the risks associated with the clean lending exposure of the security borrower, these markets have evolved into a collateralised format as discussed earlier.

Repo determines forward prices of cash instruments

Repo cash flows can be mimicked by going long a bond in spot and selling futures on it (with the bond to be delivered on maturity). Difference between the futures and the spot price would imply the repo rate or interpreted the other way, given a repo rate and a spot price the future/forward price of the bond can be determined.

\[ \text{Future / Forward price} = \text{Current price} \times ( 1 + \text{Repo rate} \times \dfrac{n}{ 365} ) \]

Cash Futures Basis as a risk barometer

The notation above calculates futures/forward price of a security/bond using the market repo rate, but for securities/bonds that have a deep futures market an implied repo rate can be calculated. Any basis between the implied repo and market repo (former lower than latter) would reflect the ‘special-ness’ of the security/bond on repo

Trivia. BoJ’s YCC and ‘Special-ness’ implied by JGB futures prices – market-wide bets on BoJ doing away with YCC (early 2023) triggered a wave of shorts on the cheapest to deliver bonds (those that would be delivered on the futures contracts) also part of the YCC operations. As the central bank bought more and more of the bonds under its operations it ended up being the sole lender to those who wanted to short them (short forwards) and in turn the sole buyer of the same in the cash market. This created more than a 100% beneficial ownership for BoJ on some of these bonds with large short forwards positions with the market. Basis between the implied repo rate on certain bonds (as calculated by JGB futures that built large short positions and their cash prices) and the market repo rate reflected by the JGB yield curve was a reflection of the ‘special-ness’ of those bonds; implied repo rates dropped to as low as -5%. Negative carry on the ‘special on repo bonds’ finally realised at the time of futures settlement as prices converged to cash markets.

Cross Currency Repos

When the currency of the cash lent is different from the currency of the underlying asset it is understood as a cross currency repo.

• Pricing/Hedging can be broken down into two components – cross currency swap on the currency of the underlying versus the currency of the cash lent and the repo rate on the underlying.

• As an example think of a local Indian Bank that’s surplus in INR cash and is in need of USD. If the bank could borrow dollars from a USD investor by lending its local sovereign bond (IGB), the investor would lend its dollar cash at the local repo rate equivalent USD interest. Assuming the same tenor India repo rate at 6%, and USDINR Cross currency swap at 5% vs USD SOFR, the cross currency repo rate for borrowing USD cash would be USD SOFR + 100bps.

Asset Swaps – Is a term used to describe a ‘swapped’ return whereby an investor in a cash product desires to convert the return on it into the same currency or their home currency or another currency floating or fixed rate.

• Same currency asset swap converting a fixed coupon bond into a floating rate bond can be seen as yield differential between the same currency bond and swap yield. If 3y KTB (Korea Treasury Bond) yields 4.5% and 3y IRS in KRW is at 4% then a swap whereby one pays 4% and receives KRW floating rate + 50bps will have a zero Present Value (PV) and the 50 bps is the same currency asset swap spread.

• Cross currency asset swap – facilitates conversion of at fixed coupon on a bond in currency A to a floating or fixed coupon in currency B. So in a marketplace a foreign investor who is long a 3y KTB @ a fixed coupon of 5% would fully hedge the cash flows on the bond to convert the returns to a floating rate in another currency. They would pay the fixed coupon of the bond to the dealer and receive the equivalent let’s say USD SOFR + spread (in basis points) on it. Notice that the fixed KRW rate is akin to the fixed KRW cross currency rate as in a fixed/float cross currency swap vs USD SOFR and the spread over USD SOFR would be equivalent to the difference between this KRW fixed coupon and same tenor KRW CCS yield.

Connecting the Dots. Referring to the section on cross currency repos we can see now that asset swap level for an asset should theoretically be the same as the cross currency repo price of the asset.

Liability Swaps – Similar to an asset swap this is a term used to describe the swapping of funding cost of a liability of the borrower into fixed or floating rate in a currency of their choice.

• Consider an onshore Korean Corporate’s fixed rate KRW liability which can be swapped into KRW floating rate by receiving fixed rate KRW IRS or in this case a fixed/float liability swap with a dealer. The corporate borrower would receive the coupon on his fixed rate loan and pay a KRW floating rate index + spread (in basis points) to the dealer.

• And a Korean Bank’s fixed rate USD liability can be swapped back into KRW floating rate +/- spread with an interbank dealer by a) receiving fixed USD coupon and paying USD floating rate + spread b) receiving USD floating rate + spread and paying KRW fixed rate, in other words paying the USDKRW Float/Fixed cross currency swap. If it were a USD fixed rate loan of a corporate it would likely be swapped back into a fixed rate KRW loan by using a fixed/fixed USDKRW cross currency swap.

Asset and Liability swaps therefore suggest the degree of attractiveness for both an investors’ return and a borrowers’ funding cost across different currencies relative to their local currency return/cost of funding.

Table 2 – Japan bills/JGB yields swapped into USD, EUR, GBP, AUD

Source: Pandemonium.

The table above compares the swapped returns on JTDBs (Japan Treasury Bills, across tenors) in four different currencies with their local bill yields, both stated as an asset swap spread over their respective floating benchmarks. To understand the calculation let’s consider the investment of a US based investor in a 3 month Japan treasury bill trading at -0.17% yield swapped into USD. Order of cash flows would look like the following:

• JTDB yield can be converted to a floating rate JPY OIS + spread by paying 3m JPY OIS.

• This return in turn can be converted to a USD SOFR + spread expression by paying USDJPY 3 month cross currency basis.

• Combining a and b would amount to JPY floating leg being offset and the fixed 3m JTDB yield being converted to USD SOFR + spread.

• Similarly JPY bill yields can be converted to other currencies floating rates + spread and their relative attractiveness can be assessed by comparing it to local bill yields as expressed in the same benchmark floating rate + spread.

• In our example above – foreign investors from across regions considered above would find investing their money into Japan bills and swapping it back to their home currency more attractive than their local sovereign bills.

• For an asset swap trader the calculations above are the first step to identify investment opportunities. But the ability to monetise/capitalise on such an opportunity would also be a function of i) rating of the underlying asset (Japan sovereign as in the example is highly rated as A+ by S&P) ii) country limits (also a function of rating of the underlying asset) on Japan in this case.

In the emerging markets world, Korea and Taiwan are two current account surplus nations with ageing demographics, mature growth cycles and hence the need to generate returns on domestic savings via exposure to foreign currency assets; onshore asset managers/lifers have large dollarised investment books. Much like the cash flow dynamic above that swapped the return on a foreign currency to the investor’s home market floating index + spread, local EM investors also compare the returns on foreign bonds swapped into their home market floating index + spread with local sovereign/corporate bonds yields. But the direction of cross currency basis flips in this case i.e. a Korean asset manager would receive USDKRW cross currency basis to swap the returns on a USD corporate bond into 3m CD + spread.

Similarly for liability swaps consider an example of a Korean Corporate contemplating raising USD funding. A key difference here vs asset swapped returns would be to assess attractiveness of a foreign currency funding by converting it to local currency + spread (let’s say KRW 3m CD + spread) and comparing it with the local corporate issuance yields expressed as 3m CD + spread again. Decision making process for raising 3y USD (as an example) funding would involve:

• 3y USD Corporate bond yield which would be a function of both the underlying 3y UST yield and the credit spread.

• For simplicity this can be converted to a USD SOFR + spread by receiving 3y fixed rate USD SOFR swap.

• And this in turn can be converted to a 3m Korea CD + spread by paying a 3y USDKRW cross currency basis swap to arrive at the equivalent local benchmark floating rate + spread.

• Comparing this spread with the equivalent 3m Korea CD + spread funding cost of the onshore corporate issuance yield would be key for arriving at the funding decision.

• Other considerations for foreign currency fund raising would be issuance costs (syndication fee, legal costs, listing costs et al), timing of issuance, regulatory permissions, ability (both of the issuer and market depth/structure) to issue in a specific foreign currency market.

To summarise – the impact of cross currency basis on asset and liability swaps for asset managers and corporate borrowers of the same country is diametrically opposite. Cash flow description above makes it clear that a deeply negative basis swap would ‘reduce’ the asset swap spread and ‘add to’ the relative attractiveness of foreign currency funding vs local funding, and vice versa.

Collateral Swaps – is the exchange of two different assets for any given tenor. The lender of the lower quality collateral generally pays a spread to the lender of the higher quality collateral. The assets can be and generally are in two different currencies. The motivation for these trades is largely portfolio optimisation wherein a passive investor could enhance the portfolio returns by swapping collateral (credit risk) without necessarily taking market risk on the weaker underlying. Treasuries in banks use these to acquire say higher yielding but High Quality Liquid Assets (HQLA) assets again without taking the associated market risks.

Typically above investment grade internationally rated (offshore) and equivalent locally rated sovereigns qualify for HQLA for the Global Banking system. In the same vein, (from the previous section) – Japan sovereigns (high rated and HQLA eligible) are/can be higher yielding versus local sovereigns, the only difference is that the holder would be exposed to mark to market risk.

Connecting the Dots. One can also think of collateral swaps as undertaking a repo purchase of an asset against a repo sale of the other asset.

Pricing of a collateral swap

The spread to be charged for a collateral swap should be the differential of the respective repo spread/asset swap spread of the exchanged assets. Or said another way the lower grade asset gets financed by the higher grade one, hence the difference between the asset swap return on the lower grade asset and repo funding cost of the higher grade one guides the collateral swap pricing.

As an example – a foreign dealer who buys a Korean bond at an asset swap spread of USD SOFR + 100bps would be willing to pay a spread of ~70bps to do a collateral swap of the Korean bond against an IG bond. This IG bond could be repo-ed/ traded at an asset swap spread of USD SOFR+30bps. The dealer can use the IG asset to generate funding at SOFR +30bps and can fund the Korean asset at an overall cost of USD SOFR +100bps (including ~70 bps collateral swap spread).

Bond Forwards

Bond Forward are a product used by investors who anticipate the need to deploy cash in the future but want to lock in the current level of rates for that future purchase. This can be because a) they do not have the cash for immediate deployment b) they are in need of duration for their portfolio to correct duration mismatches between assets and liabilities c) for leveraged/enhanced return d) relative attractiveness of bonds vs swaps i.e. wider bond-swap spreads. You can simply think of it as a bond trade being priced for a future date, where the pricing is based on the spot price of the bond and the anticipated funding rate for the forward tenor. In the repo section we explained how the futures/forward price and spot price determine the implied repo/ funding rate of the bond. As a corollary, if we know the spot price and the funding / repo rate of a bond we can derive the no-arbitrage forward price of the bonds just like the forward prices on swaps.

If the yield curve is upward sloping i.e. repo rate for the tenor of the bond forward (say a 5y tenor of a 5y forward 20 year bond) is lower than the yield on the longer tenor bond (25 year bond) then the forward bond price will be lower (yield will be higher) than the current price of the bond.

Notional limit on being able to offer bond forwards would depend on the balance sheet capacity of banks.

Trivia.

We have seen increased use of bond forwards by lifers in markets like Korea and India to increase duration risk in a portfolio similar to receiving fixed on long dated IRS but at a better yield given the positive bond-swap spread. The dealer (seller of the bond forward) needs to cover his short position on the bond by buying the bond in the cash market and or think of cheap ways of funding the same since emerging markets don’t really have active term repo markets.

• For eg. pricing of a 2y forward 30y IGB would involve buying the 30y IGB and pricing/funding it for 2 years at OIS + spread, effectively running a balance sheet position and a funding mismatch.

• For a highly rated market like Korea with attractive asset swap levels, one can think of tying up cheap KRW funding by doing a combination of collateral swap and a USDKRW cross currency i.e swap for the forward tenor. For instance a 2 year forward bond structure can be executed by first doing a 2 year collateral i.e. swap – exchanging KTBs for USTs at a fixed running fee of say 25bps (something that’s incentive enough for the UST lender). The USTs can be refinanced (repo-ed) for term USD cash which can be converted to KRW cash by doing a 2y Cross currency swap to fund the KRW bond purchase.

Total Return Swap (TRS)

TRS is a contract wherein the buyer gets access to the economics/ cash flows of an asset on one leg via a derivative versus paying funding on the other leg of the swap. Key difference between a TRS and an asset swap – in case of the latter one physically holds the asset, returns of which are directly credited to asset holder with the swap used to hedge the interest rate or FX risk, while in a TRS all underlying returns of the asset are passed on to the holder but they don’t physically hold the asset.

• The underlying asset could be of any type with certain/dfefined or uncertain cash flows (bond/fund/equity/real estate). Note the underlying asset could also be of any maturity or even a perpetual as the TRS buyer is only buying the return of the asset for a specific time period.

Connecting the Dots. The funding leg could be seen as the repo price of such an underlying asset else arbitrage conditions could exist.

• Valuation of the asset leg of the TRS – despite being a derivative that would conventionally reference CSA documentation, the present value calculation of the asset price at the time of unwind automatically references its current market price (in case of bonds it’s the current YTM). This is because the PV obtained from CSA discounting won’t align with traded market levels of the underlying as funding costs differ. This is a well accepted understanding between both the TRS seller and buyer who can unwind the TRS at any time before the swap tenor sometimes with an additional break funding charge.

For those not familiar with break funding – this is an additional charge levied by the seller of the TRS (writer) who is expected to pay up their treasury in full the cost of the TRS funding tenor. A premature unwind would require the TRS buyer to pay up (make-whole) the residual funding charges to the seller. These are also known as ‘make-whole’ charges.

• Since only the cash flows of the underlying asset are paid by the TRS writer – the title of the underlying asset remains with the TRS writer who also continues to own things like voting rights etc.

• TRSs are mainly used to address access issues i.e. TRS buyers have hurdles in directly accessing the markets of the underlying, for eg. ODIs (offshore derivative instruments are TRS exposures for offshore investors on onshore INR assets) in India.

Trivia. TRS contracts are bilaterally negotiated and lack standardisation (unlike CDS contracts), hence dealers can differ in their valuations of such contracts even if economic terms are similar. As a result, novation of the contract to another dealer/bank gets difficult. For instance TRS valuation of a fixed rate sovereign bond to maturity could also be valued as risk free cash flows in that currency (i.e. like a fixed leg of an onshore IRS) since we know that the cashflow up to the bond maturity is fixed.

Carry on an Investment – probably one of the most overused terms in financial markets across asset classes is carry and roll, often used interchangeably. Let’s tackle each of them separately but before that – in simple terms one can look at the carry + roll (expressed in basis points) as the change in Present Value of an investment/portfolio due to the ageing of that investment/portfolio of trades while assuming no change in the underlying market conditions (i.e. no change in yield curve). Carry here refers to the net accrual on an investment (adjusted for its funding cost), while roll is the capital appreciation/depreciation due to the change in yield as the investment ages.

Let’s address them with different examples here:

• For cash instruments, one day carry would be the daily accrual adjusted for the funding cost, while a one day roll is the change in the yield / YTM of the investment with the passing of a day given no change in the shape of the yield curve.

• For a fixed-float IRS, one day carry would be the daily net accrual implied by the difference between the fixed rate and the current floating rate, while one day roll would be the change in the PV of the swap with the passing of a day.

• For example a 5y KRW IRS at 4% vs a floating rate at 3.5% has 50bps of annualised positive carry for a receiver of the fixed rate. The roll for a day would be the PV of the yield differential between a 5y and a 4y 364 day IRS.

• Extending the above definition, carry plus roll can also be computed as the difference between the zero PV/zero arbitrage/breakeven forward rate and its underlying spot rate.

• For eg. Assume that current 1y Korea IRS is at 3.65% and current 3m CD fixing is at 3.50% then 3m forward 9m IRS priced off the current yield curve is at 3.70% breakeven {calculated as \( (3.65 - 3.50 \times 0.25) \times \dfrac{ 4 }{3} \) }. Further also assume the current 9m IRS is 3.58%.

• For a received position then, carry = 3.65% – 3.50% = 15 bps annualised (with quarterly payments or 3.75bps absolute for 3 months) and rolldown = 7bps absolute (3.65% – 3.58%) for 3 months on a 9 mnth tenor or 5.25bps absolute for 3 months on a 1yr tenor.

• Therefore, Total carry + rolldown over a 3m period = 3.70% – 3.58% = 12 bps for 9 months or 9bps in 12 months

• Notice from the example above, carry + rolldown of a spot 1y IRS for 3 months is equal to the 3 month rolldown for a 3 month forward 9 month IRS dealt today.

• Alternatively, the forward breakeven rate (3.70) minus the current spot rate (3.65) would be the absolute carry for a 9 month tenor which is the same as 3.75bp for a 1 year tenor. And the 3 month roll would be 1y spot level (3.65) minus the current level of the rolled down tenor (3.58), equal to 7bps for 9 months. That ties up with carry + roll of 12bps for 9 months or 9bps for 12 months.

• With most yield curves being inverted (negative slope) for most part of 2023, carry is negative on a received position as the forward breakevens are below the current spot. In the same vein steep yield curves (positive slope) would be positive carry on a received position.

• Sign of the roll would be the same as the sign of the carry for continuously positive and negative yield curve.

Graph 1 & 2 – Carry & Roll Graphs

Source: Pandemonium.

• What’s a positive carry position for a receiver is negative carry for a payer and the same would hold true for the roll also.

• Carry on FX trades – can be understood in exactly the same manner as for interest rates above, the only difference being the comparison of FX swap tenors on a common unit of time. Let’s take the example of two different currencies – one that trades at a discount to spot (negative points for TWD or an appreciation bias) and the other that trades at a premium (positive points for INR or a depreciation bias).

Source: Pandemonium.

Carry like for interest rate swaps can be defined as the daily points accrual vs the funding. For FX deliverable markets the daily funding would normally be denoted by the Tom/Spot FX swaps but those do not exist in the for non-deliverable FX markets. So we typically end up using the 1m (or the most liquid front end tenor) points as proxy for the funding leg; as such we use the monthly carry as a proxy for daily carry.

From the above table note that receiving INR 2y points at 16.375 pips per month and funding it by paying the short end say 3m at 10.8 pips per month would imply a carry of INR 5.575 pips per month if the curve remains unchanged. As for the roll-down just like for interest rate swaps – the 6mfwd6m points in INR are at 93.5pips (162 – 68.5 = 93.5) vs 6m points only at 68.5 implies a 6m roll down of 25 pips or 4.167 pips per month (that’s again assuming no change to the curve).

For assessing the richness/cheapness of the points curve, One needs to be careful to not rely too much on just points per month as the interest rate curve steepness / flatness at the very front end and relative funding on local vs foreign currency plays a big part too upon adjustments for interest rate parity/other (changing) demand vs supply dynamics.