Inefficiencies of Basis Swaps to Hedge Foreign Exchange Risk

Abstract

We find that a cross currency basis swap between the U.S. and emerging economies should not be interpreted as a currency hedge, as the exchange rate risk associated with these transactions is quite high. These risks are significantly lower for a basis swap between the U.S. Libor and Euro Libor. Overall, the use of a cross-currency basis swap requires an assessment of the expected trajectories of exchange rates and the associated risks. Offshore funding is thus an imperfect substitute for onshore funding of operations in a local currency.