CNH Forward Pricing When the Swap Market Dislocates
At 09:40 on a Monday, a Hong Kong toy exporter calls your CNH desk. It wants a firm three-month outright price to sell USD 6,000,000 against CNH, value spot. Your screen shows USD/CNH spot 7.2480/7.2490 and three-month USD/CNH swap points 190/230. Three-month CNH HIBOR is 6.40/6.55% and three-month USD SOFR is 5.28/5.32%. Your bank funds CNH at HIBOR+40bp because of a month-end balance-sheet charge, and corporate forwards carry a 10bp annual credit spread added to CNH funding. The client says another bank quoted 7.2720 and asks you to match it. Your credit limit for this client is USD 10m. Overnight CNH HIBOR jumped after a large IPO subscription locked up liquidity, and the swap market is thin. The relationship includes good HKD and USD deposit balances. You must decide whether to hedge in the swap market or warehouse the position.
1. Calculate the fair three-month outright from (a) the swap market and (b) your bank's internal CNH funding, and state the economic result of matching the client at 7.2720 under each route.
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Swap-market route
- Spot mid = (7.2480 + 7.2490) / 2 = 7.2485.
- Swap-points mid = (190 + 230) / 2 = 210 pips = 0.0210.
- Fair mid outright = 7.2485 + 0.0210 = 7.2695.
- If the bank buys USD forward from the client at 7.2720 and hedges by selling USD forward in the market, it can deal at the bid side of points (190), i.e. 7.2480 + 0.0190 = 7.2670. Buying at 7.2720 and selling at 7.2670 loses 50 pips = USD 30,000 on USD 6m.
Internal funding route
- Borrow CNH at the offer side: 6.55% + 0.40% + 0.10% credit = 7.05%.
- Invest USD at the bid side: 5.28%.
- F = 7.2480 x (1 + 0.0705 x 0.25) / (1 + 0.0528 x 0.25) = 7.2480 x 1.017625 / 1.0132 = 7.2797.
- Matching 7.2720 is 77 pips below internal cost = USD 46,200 loss on USD 6m.
Conclusion: the competitor's 7.2720 is above the hedgeable market bid (7.2670) and below the bank's internal cost (7.2797). There is no route that makes 7.2720 profitable; the choice is between declining to match and accepting a quantified relationship loss.
2. Explain why the swap-market forward and your internal funding forward differ, and what that implies for warehousing the position.
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The two numbers differ because covered interest parity prices a forward off the marginal cost of funding in the interbank market, not off any single bank's balance sheet. The swap market at 190/230 embeds an implied CNH funding cost close to HIBOR mid plus a small liquidity premium. Your bank's internal cost is HIBOR offer + 40bp month-end charge + 10bp credit, so it sits roughly 50-60bp above the market's marginal CNH cost. The gap is a funding-value adjustment, not an arbitrage.
Warehousing the client's USD 6m forward means the bank effectively borrows CNH for three months at 7.05% to buy USD spot and invests USD at 5.28%. It takes three risks: (i) CNH funding risk if HIBOR spikes further after the IPO lock-up; (ii) balance-sheet cost risk if the month-end charge is reapplied at a higher rate; and (iii) counterparty credit risk on the client. The 77-pip shortfall is the price of using the bank's balance sheet instead of the swap market. A dealer should only warehouse where the relationship's deposit and flow value demonstrably exceeds that shortfall, and the decision should be documented, not made ad hoc.
3. What would you quote and what client-facing explanation and alternative would you offer?
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I would not show 7.2720 as a firm two-way price. I would quote a hedgeable level, around 7.2660/7.2680, and explain that the CNH swap market has widened because overnight HIBOR jumped after the IPO lock-up and liquidity is thin. The client is selling USD, so the bank buys USD; the bank's bid must be at or below what it can hedge at (7.2670) if it is to avoid a loss.
If the relationship justifies accommodation, I would offer one of three alternatives rather than an outright loss:
- Split the order into two tickets and price each off the prevailing swap points, reducing the risk of quoting a stale level in a thin market.
- Offer a three-month CNH FX option or a participating forward, which shifts part of the forward-points risk to the client in exchange for upside participation or a lower upfront cost.
- Price against the client's deposit relationship, but only with a documented relationship-pricing approval showing the expected deposit spread covers the 50-77 pip shortfall.
I would also tell the client plainly that the competitor's 7.2720 may reflect a different funding base or a warehouse position, and that the client should ask whether that quote is firm and hedgeable. This is transparent, avoids misleading the client about market conditions, and protects the bank from a hidden loss.