October 9th, 2012, 12:14 am
Hi,Im having a very difficult time understanding how the inclusion of the CCY basis curve, post credit crisis, has modified the pricing of CCS.For example, today (just as before the crisis) when a EUR/USD CCS is entered into party A borrows X?S USD from, and lends X EUR to, party B. During the contract term, A receives EUR 3M Libor + α from, and pays USD 3M Libor to, B every three months, where α is called the cross currency basis spread, and it is agreed upon by the counterparties at the start of the contract. So alpha is the spread added to the EUR LIBOR curve to make the trade fair at the onset.Now, post crisis, is what has changed that the cross ccy basis spread is considered in the pricing through the life of the deal. So say the above deal was entered into 3 months ago and it is being re-priced today. Do we add a basis spread to the EUR LIBOR rate when forcasting future cash flows, in order to represent the changes in the FX forward rates that we are forcasting today? So in total the EUR forward rate used to calculate the forward cash flow at each point is actually the EUR LIBOR rate + alpha (set at onset of trade) + BA (basis adjustmet)? Please let me know if my understanding is correct or am i completely wrong here, thanks