Treasury Broadsheet

The drop in the NZD/USD basis swap following the shift to US SOFR

To start with, what is a basis swap? A basis swap is an interest rate ‘swap’ that converts interest (and usually principal) payments in one currency into those of a different currency. Basis swaps are focused on the floating-to-floating rate leg between currencies, e.g. from USD SOFR to NZD BKBM. 

Typically, basis swaps are used to hedge the principal and interest payments that arise when an entity borrows or invests in a foreign currency. Any fixed rate hedging, say in USD, is managed separately with a regular interest rate swap (e.g. from fixed to floating). Relatedly, the FX risk component of any transaction (i.e. principal payments and repayment) can also be wrapped into this conversion, and this is known as a Cross Currency Interest Rate Swap (CCIRS), of which the basis swap is included. 

A basis swap is expressed as a ‘spread’ (usually in basis points), which is applied (either added or subtracted) to the non-USD denominated currency. This basis spread reflects the cost of swapping into another currency on a temporary basis. The basis spread applied is a reflection of the credit and liquidity risk of underlying money market rates (Bank Bill Reference Rates - BKBM vs. Secured Overnight Financing Rate - SOFR) as well as the demand and supply for either currency involved in the CCIRS (NZD vs. USD). The spread is applied to periodic interest rate payments that occur between the parties involved. This article aims to explore reasons for the decline in NZD/USD basis spreads over the past few years.

Assuming a New Zealand-based borrower is raising funds offshore (e.g. in USD), under a full CCIRS they will exchange the principal amounts (in both currencies) at the prevailing market exchange rate. This is the initial ‘swapping’ of currencies. This occurs with a swap bank or similar counterparty.

The periodic interest payments will then occur over the life of the swap. These payments are based on the relevant money market reference rates (BKBM and SOFR). The additional spread attached to the NZD denominated flow of funds is usually held constant over the life of the swap (i.e. the basis swap term matches the term of the underlying instrument). This spread is determined at the inception of the swap (i.e. the basis swap spread). 

Finally at the conclusion of the swap (and loan), the original principal amounts will be swapped back, at the same rate used in the first exchange and used to repay the lender.

Why has the spread on the NZD/USD basis swap decreased in recent years? Firstly, let’s examine NZD/USD basis spreads over time (January 2015 - January 2025).

Prior to the GFC, there was minimal cost to basis swap spreads given the loose financial regulations across the major economies and the general abundance of US dollar funding spread through global financial markets. The tightening of financial regulation that followed, such as higher capital requirements and more stable funding sources, reduced excess US dollar availability and drove up the cost of basis swaps (due to a mismatch between the supply and demand for USD funding).

For New Zealand, this drove the NZD/USD basis swap spreads higher - to between 25-30 basis points for 7 to 10 year tenors. For simplicity purposes, a positive spread (which is added to the non-USD denomination) essentially means that New Zealand borrowers were forced to pay a premium to swap out of USD lending into NZD denominated debt.

Compare this with the landscape now, and it's clear to see that spreads have come in, and have even shifted negative in some tenors of swaps. So what has driven this movement and how much is explained by the change in US floating reference rates? 

Above we discussed that a driving function of the basis spread was the underlying credit risk of each money market reference rate. The reference rate in New Zealand is the Bank Bill Reference Rates (BKBM). BKBM is calculated using data collected from a panel of contributor banks in which they submit the rates at which they’re lending unsecured funds to other banks (during a measurement window) on a daily basis. The highest and lowest submissions are then omitted and an average is calculated. This mechanism was first introduced in the 1980s and has not materially deviated in its method of calculation.

The money market reference rate used in the United States has undergone some shifts though. Initially, USD LIBOR (London Interbank Offered Rate) was the main reference rate. This rate was calculated similarly to BKBM, from a panel of bank submissions with the same omission of the highest and lowest estimate, in USD. However, due to scandals relating to the integrity of LIBOR, the Federal Reserve began looking at alternative measures that were a better reflection of U.S. money markets and not manipulatable.

Eventually, SOFR (the Secured Overnight Financing Rate) was decided as the preferred replacement (circa June 2017). This began being formally published by the Federal Reserve in April of 2018, though this transition period was gradual, with many contracts and financial instruments still referencing the USD LIBOR until their cessation dates. 

SOFR is calculated using real-life transactions in the overnight repurchase market, where funds are lent while being collateralised with US Treasury Securities. In this sense, the credit risk element fundamentally differs between SOFR and LIBOR, as SOFR is a rate secured by US Treasury securities which are largely considered ‘risk-free’. A simple way of visualising the difference between SOFR and LIBOR is plotting them against each other. As SOFR has a lower credit risk when compared to LIBOR, we’d expect that this would be reflected by a lower overall rate. This is evident in the premium that LIBOR has generally traded at above SOFR (has averaged ~ 32 bps since June 2018).

The expectation (in terms of basis spreads) would be that once SOFR became fully implemented, the basis spread for NZD/USD would reduce, as now there is less compensation required for the non-USD leg of the swap due to the relative reduction in credit risk associated with SOFR.

Let’s take a closer look at the above chart with some key events identified on it, and see if this expectation holds true.

The expected movement in basis swap spreads from a change in the underlying credit risk for US SOFR ultimately did occur once the main market reference was updated. A gradual decline in spreads did occur following Event B, when SOFR starts to be published and declines ahead of the cessation trigger. Although a slow, slight decline does play out following this event, the main trigger is Event C, with the cessation of non-USD LIBOR contracts as well as restrictions on USD LIBOR contracts/derivatives. Following up to and post Event C however, a sharp decline in spreads occurs as the market adjusted to increasing liquidity levels regarding SOFR related contracts/derivatives. This ‘adjustment’ then calms as the transition from US LIBOR to SOFR is finally completed, with spreads (in general) closer to zero than they have been in the past decade. In general, from the time SOFR began being published, to the point where LIBOR was formally discontinued, NZD/USD basis spreads have dropped ~30 bps. 

Overall, the transition from LIBOR to SOFR has driven a material move lower in NZD/USD basis swaps. However, other factors such as the level of USD liquidity, the demand for NZD liabilities (or funding) from local banks and, to an extent, the path and predictability of relative monetary policy all arguably have some influence on the daily volatility still observed in basis markets. 

For risk managers and New Zealand borrowers, the decline has generally been helpful. However, an increase in interest rate volatility, an inverted swap curve (in NZ and US) and an inversion of US swap-bond spreads (where swap rates are trading below bond yields) have made USD funding less attractive given that investor return expectations (typically set above bond yields) remain elevated and the swapped NZD cost of funding has been less compelling than other markets.

Authored by Sam Duncan

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Exploring elevated risk aversion in NZD/USD currency options

The trading of the NZD/USD currency pair often mirrors broader economic sentiments and risk perceptions. During times of heightened uncertainty, such as global financial upheavals or geopolitical tensions, risk assets, including the New Zealand dollar (NZD), often experience increased volatility. 

This volatility is evident in the pricing dynamics of currency options, where the cost disparity between calls and puts becomes more pronounced. Specifically, the premium for out-of-the-money (OTM) puts rises relative to OTM calls, resulting in a distinctive volatility "smirk." 

This pattern reflects investors' growing risk aversion and the negative skewness observed in near-the-money options. By exploring this trend, this article aims to shed light on the elevated risk aversion in NZD/USD currency options and the implications for risk management strategies, particularly through the use of exporter collars.

NZD/USD options during market volatility:

During periods of heightened uncertainty, the volatility of risk assets, including the NZD, elevate. However, the pricing of calls vs. puts shows an increasingly diverging trend → in order to have the right to buy NZD at a future date at a rate lower than the forward price (out-of-the-money), the premium becomes more expensive. This is depicted by the smirked shape of the volatility plots (shown above), where OTM put premiums are higher relative to OTM calls. The slope of this relationship, or skewness, is negative when looking at near-the-money (more liquid) options.

IV curves flatten three months later

Looking at key instances when the NZD/USD exporter filter test becomes active, these volatility curves not only lower (implying less volatility in NZD/USD), but also become less skewed. This means the asymmetric risk-reward of collar options becomes less favourable (the best rate case moves up to a greater extent than the worst case rate).

This shows that during filter activation (heavily suppressed periods in NZD/USD), markets tend to price in even more negativity. As hindsight would suggest, it’s possible to say that markets pushed NZD/USD down too far in the first instance. Instead of viewing NZD as a ‘bargain’, markets become more fearful, offering the opportunity for a prudent risk manager to take advantage of them, especially if they have moved towards maximums of policy on forward FX contracts.

NZD/USD skew during periods of filter test activation vs 3 months after activation:

Exporter collars to take advantage of risk asymmetry

• Zero-premium collars offer an asymmetric risk/reward relationship when the seven-year filter test is active.
• Greater uncertainty over longer time horizons causes 6 month collar structures to skew further towards offering a better best-case-rate. 
• Across all instances of filter test activation (barring the onset of Covid),  NZD/USD traded notably higher than the initial activation rate. 
• This suggests option-implied probabilities for the future FX rate are much too skewed to the downside (which often appears valid during periods such as the GFC and Covid, but the key is that pessimism for NZD/USD is often overpriced in such instances.

NZD/USD zero-premium collar during periods of filter test activation:

The analysis of NZD/USD currency options during periods of heightened uncertainty reveals a consistent pattern of increased risk aversion. The volatility curve and negative skewness in option pricing underscore the market's tendency to overprice pessimism, often pushing the NZD/USD rates lower than warranted. 

However, this environment also presents unique opportunities for savvy risk managers. By leveraging zero-premium collars, particularly when the seven-year exporter filter test is active, investors can take advantage of asymmetric risk-reward dynamics. 

Historical instances demonstrate that NZD/USD tends to recover and trade higher than initial activation rates, suggesting that the market's bearish outlook is frequently overstated. Understanding and navigating these trends can provide strategic advantages in managing currency exposure and optimising risk-return profiles.

Authored by Ben Bridgman

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What’s the right size for a treasury team?

The short answer is, there is no one size fits all solution. Steve Jobs once said, “Great things in business are never done by one person. They’re done by a team of people.” This sentiment holds especially true in the realm of treasury management, where collaboration and the segregation of duties are critical to maintaining integrity and efficiency. 

The size and importance of the treasury team depends on a number of factors, such as the size of the organisation, nature of the business, complexity of financial transactions and the capabilities of those responsible for financial management.

Segregation of duties ensures that no single employee can both commit and conceal errors or fraud, whether intentional or accidental. This principle is upheld by involving multiple individuals and systems throughout the transaction lifecycle. In larger treasuries, this is traditionally achieved through the division into front, middle, and back offices.

Roles and responsibilities in treasury

This segregation of duties ensures the integrity and efficiency of financial operations, minimising errors and fraud by distributing responsibilities across different personnel. The split of front office and back office tasks ensures that the person accounting for the deal isn’t the person who is executing the deal and vice versa. Thereby reducing the risk of error or fraud. A typical treasury transaction process is outlined below:

However, not all treasuries have the luxury of a full three-office structure due to the size of the team. Particularly in small or medium sized enterprises (SMEs) the size of the treasury team is often quite small. This makes the segregation of the front, middle and back office tasks difficult. In these cases, it is still important to ensure there is some segregation between the transacting of deals and the confirmation and accounting of them. This will reduce the risk of error or fraud in the business. 

When considering the size of the team, it is important to think through scenarios such as what if key personnel are away? Are there back-up personnel who have the capability to perform the role? And how will segregation of the front and back office tasks be maintained?

The evolving role of technology

The COVID-19 pandemic and other geopolitical events have highlighted the importance of robust risk management and forecasting capabilities. Post a period of high inflation and now with continuing volatility in interest rates, treasury teams must adapt their risk management strategies.

Technology is playing a transformative role, with treasurers needing advanced skills to leverage data and automation. Modern treasury management systems (TMS) automate processes and create workflows that clearly delineate responsibilities between different roles. Role-based access ensures that front-office staff, who are responsible for trading and deal execution, have different permissions compared to middle office staff, who handle risk management and compliance and back office operations, who are responsible for settlement and accounting.

Having an audit trail that records every transaction and change made within the system will make it easy to identify and discrepancies and errors are quickly identified and addressed.

Real-time data and reporting help middle office teams monitor the front office activities and ensure compliance with risk management policies. These tools provide insights into transactions executed, exposure forecasts and compliance with the treasury policy parameters. Many businesses will use either a TMS or a treasury reporting system such as PwC Treasury Intelligence to monitor and manage their financial risks.

There's no “One Size Fits All” for a treasury team, and the ideal setup depends on the business size, complexity, risks, and strategic priorities. It is important to have a right-sized team which is capable of managing risk effectively while maintaining segregation of duties. Adopting technology may also assist in improving the integrity, efficiency and accuracy of treasury processes and reporting. 

Authored by Rajeev Verma

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