Inflation differential as a driver of cross-currency basis swap spreads

Abstract

Over the last decade, the foreign exchange derivatives market has witnessed a collapse of covered interest parity (CIP). Not only does this collapse give rise to large deviations from CIP, it has unlocked a stream of exploitable arbitrage opportunities across currencies. In this paper, we introduce two new factors – inflation differential and relative economic performance – as potential drivers of deviations from CIP. Employing data on G10 cross-currency basis swap spreads viz a viz the U.S. dollar, we document a striking new evidence that higher inflation differential and incremental improvement in relative economic performance drive the basis wider, and hence arbitrage profits higher for U.S. dollar-based investors, in the post crisis period. Our main empirical results in general are robust to an extended number of controls, variations in sampling frequency, and consideration of alternative specifications, but the additional explanatory power is low.