Impact of Collateral Currency Choice on Valuation and Hedging of Differential Swaps
ORIGINAL / Choice of Collateral Currency in Differential Swaps
This paper decouples collateral currency from contractual cash flow currency and derives explicit pricing and hedging strategies for differential swaps referencing backward-looking overnight rate averages (including SOFR swaps as a special case) amid the LIBOR-to-RFR transition, showing that collateral currency choice has non-trivial effects on valuation and risk management through discounting adjustments and payment-date weights.
01 ABSTRACT
The study extends Bickersteth et al. (2026) by allowing the collateral account to be denominated in a currency different from that of contractual cash flows, and derives explicit pricing and hedging strategies via a futures-based replication approach. Numerical experiments validate the closed-form formulas, demonstrate that collateral effects can produce valuation adjustments, and confirm the effectiveness of futures hedges under discrete rebalancing. The authors argue that collateral currency choice has non-trivial effects on valuation and risk management, a view that should be interpreted in light of the model assumptions and numerical settings.
02 KEY FINDINGS
- Separates collateral currency from contractual cash flow currency, extending the pricing framework for differential swaps.
- Derives explicit pricing and hedging strategies via futures-based replication, incorporating discounting adjustments and payment-date weights.
- Numerical experiments validate the closed-form formulas, show collateral effects can produce valuation adjustments, and confirm futures hedge effectiveness under discrete rebalancing.
AI GENERATED SUMMARY / DISCOVERED BY ARXIV Q-FIN