From CIP-deviations to a market for risk premia: A dynamic investigation of cross-currency basis swaps

Abstract

The persistent deviations from the covered interest rate parity (CIP) since 2007 indicate that specific frictions continue to exist, which prevent them from being arbitraged away. In this study, we investigate the cross-currency basis swap market. We put forward the argument that the risk premium expressed via the CIP-deviation constitutes a unique market that determines its own equilibrium price after receiving feedback from various sources, including contagion within the market itself. We investigate contagion using a TVP-VAR framework of analysis that measures the extent of connectedness across the bases on all G10 currencies against the US dollar between 2007 and 2017. Our main findings indicate that connectedness is event-dependent. Furthermore, we provide evidence that net-transmitting bases are typically associated with banking sectors with significant overseas operations (e.g. EUR and JPY). Safe-haven currencies (e.g. CHF and JPY) tend to assume a net-receiving role during periods of stress. On a pairwise level, results confirm that during tranquil times in international financial markets, connectedness subdues and even reaches negligible levels – particularly for stable banking systems (e.g. CAD) or without significant US dollar funding gaps (e.g. AUD).