Cross-Currency Basis Swaps Referencing Backward-Looking Rates

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.