Cross-currency Basis Swap Research Articles

Cross-currency basis swap spreads and corporate dollar funding

This study examines the failure of covered interest parity (CIP) in long-term cross-currency basis swap (CCBS) markets. We conjecture that frictions in corporate bond markets urge firms to raise funds in one market and enter a CCBS contract to exchange the debt in a different currency. Therefore, frictions in the corporate bond market explain the failure of CIP in the long-term CCBS market. We illustrate this idea using a simple theoretical model and then explore the determinants of CCBS spreads, and demonstrate the links between corporate funding needs and the long-term CCBS market. Furthermore, we show that frictions (illiquidity in the banking sector) and credit risk are essential drivers of CCBS spreads during economic stress.

Cross-Currency Basis Swap Spreads and Corporate Dollar Funding

Cross-Currency Basis Swap Spreads and Corporate Dollar Funding

Stock market and deviations from covered interest parity

In recent times, there has been a renewed interest in covered interest parity deviations wherein financial economists have begun to analyze the drivers of cross-currency basis swap spread, a measure of the extent of deviations from covered interest parity (CIP), for different currencies. They have, however, not examined how stock market index returns associate with changes in cross-currency basis swap spreads, especially in the case of the euro basis which is the most liquid among peers. This paper provides an empirical perspective on this new question. Using standard techniques, we examine how stock market index returns relate to changes in cross-currency basis in the eurozone. Consistent with our stylized model, the empirical results show that there is a positive relationship between changes in the basis and stock market index returns whereby wider (tighter) CIP deviations go hand-in-hand with declines (increases) in stock market index returns in the eurozone. This positive relation mostly holds up, though not always statistically significant, and its size varies across different empirical specifications.

Real Output and Cross-Currency Basis Swap Spreads: Evidence from the Eurozone

Can higher real output tighten covered interest parity (CIP) deviations and lessen arbitrage profits in the eurozone fixed income market for dollar-based global investors? We address the question of determining the long-run links between selected eurozone macroeconomic factors and the long-end of the EUR/USD cross-currency basis swap spread. In our stylized model, a rise in eurozone relative real output tightens the cross-currency basis and hence lowers available arbitrage profits for USD investors looking to execute arbitrage trades whereas an increase in relative money supply together with euro depreciation widens the basis and increases potential arbitrage profits. The magnitude of the effect of relative real output dominates the magnitude of the individual effects of relative money supply and exchange rate. Our empirical results are fully consistent with the stylized model.

Interconnected Deviations from Covered Interest Parity

We investigate the dynamic interconnectedness among the major world cross-currency basis swap spreads during tranquil and turbulent times. We examine whether movements in the bases are merely anecdotal or provide evidence of contagion, the most central basis for spillover propagation, and implications for market participants. The result shows a high degree of interconnectedness among the bases in crisis periods with mark-to-market losses for existing exposures and large arbitrage opportunities for investors seeking new positions. We find evidence that spillovers in the bases propagate from the Euro, the Swiss franc, and the Danish krone to other bases.

Effects of the Fed’s enhanced swap line with the ECB on CIP deviations

ABSTRACT In this paper we study the effects of the enhancement of the Fed’s swap line with the ECB during the coronavirus epidemic on dollar cross-currency basis swap spreads against the euro, which had widened during the coronavirus crisis, reflecting greater deviations from covered interest parity (CIP). We find that the enhanced swap line contributed to making the three-month dollar cross-currency basis swap spreads against the euro less negative, i.e. narrowing the CIP deviations.

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

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.

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

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).

Inefficiencies of Basis Swaps to Hedge Foreign Exchange Risk

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.

Covered interest parity deviations in standard monetary models

Several currencies have over time exhibited persistent deviations from covered interest rate parity (CIP), resulting in non-zero cross-currency basis swap spreads. The links between these deviations and macroeconomic variables, such as those in a standard monetary model, however, have attracted less interest. In this paper, we initiate attempts to address this gap. First, we present a simple model where we allow for deviations from CIP in a standard monetary framework. With this model, we argue for the existence of levels relationships between cross-currency basis swap spreads and the macroeconomic variables. In the empirical part, we employ long-panel techniques and show that tighter cross-currency swap spreads are related to a rise in relative money supply for both European and non-European currencies and to higher relative real output for non-European currencies. We also perform error-correction analysis which reveals that the mechanism governing the adjustment to equilibrium is not the same for European and non-European currencies. However, we show that a common theme between both groups is that when there is a move away from equilibrium, it is the cross-currency basis swap spreads that adjust to ensure a return to equilibrium.

Revisiting the Comovement of Cross-Currency Basis and the Dollar: A Rolling Correlation Approach

In recent years, the idea of a robust negative association between changes in the cross-currency basis and the dollar has become a well-known theme in the finance literature. In this article, the authors revisit this topic from a purely empirical, data-driven perspective, taking a deeper look at rolling, rather than static, correlations at different windows and using the dollar bases of G10 and 10 emerging market (EM) currencies. Overall, results obtained do not support a persistent negative relationship between changes in the basis and the dollar, especially using short rolling windows. At the same time, as evidenced by the negative correlations in some historical episodes, a negative comovement between changes in the basis and the dollar cannot be ruled out, particularly at longer rolling windows. Hence the nature of the relationship appears to be dynamic, varying from negative to positive and vice-versa. As such, the evidence that the basis–dollar relationship is robustly negative appears to be window-dependent and may not always be tenable. As with nearly everything else in the financial markets, the relationship between changes in the basis and the dollar is anything but static. This result has implications for trade positioning in the cross-currency basis swap markets. TOPICS:Currency, emerging market, interest-rate and currency swaps Key Findings • Using dynamic correlations, we document no support for a consistently negative dynamic relation between changes in the cross-currency basis swap spreads and the dollar, even in the post-crisis era, especially at short rolling windows. • Instead, the dynamic relation seems to vary in direction, from negative to positive or vice-versa. Thus, like nearly everything else in the financial markets, the direction of comovement between changes in the basis and the dollar is not static. • This result has broader implications for optimal and profitable positioning in the cross-currency basis swap markets in the current world of low rates, narrower FX trading range on the back of depressed vol, and persistent covered interest parity deviations.

The Dollar and Deviations from Covered Interest Parity Revisited: New Insights from Dynamic Comovements

Recent findings that suggest a robust negative association between changes in the cross-currency basis and the broad dollar have taken center stage in the international finance literature. In this article, we revisit this issue, from a purely empirical, data-driven perspective, using G10 and 10 emerging market currencies, and employing dynamic correlations, rather than static correlations, at different rolling windows. Overall, results obtained do not support a consistently negative dynamic relation between changes in the basis and the dollar, even in the post-crisis era, especially at short rolling windows. At the same time, as evidenced by the negative correlations in some historical periods, a negative comovement between changes in the basis and the dollar cannot be fully ruled out, particularly at longer rolling windows. Hence the nature of the relation is dynamic, varying in direction from negative to positive or vice-versa. As such, like nearly everything else in the financial markets, the comovement between changes in the basis and the dollar is anything but directionally static. This result has broader implications for optimal positioning in the cross-currency basis swap markets.

Inflation Differential as a Driver of Cross-Currency Basis Swap Spreads

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 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.

The Term Structure of Cip Violations

We show theoretically that persistent deviations from covered interest parity (CIP) across multiple horizons imply simultaneous arbitrage opportunities only if uncollateralized interbank lending rates are riskless. In the absence of observable riskless discount rates, we extract them empirically from interest rate swaps using a simple no-arbitrage framework. They deliver novel quantitative benchmarks that reconcile a zero cross-currency basis with non-zero cross-currency basis swap rates. We quantify that the no-arbitrage benchmark, which is consistent with intermediary-based asset pricing paradigms, accounts for about two thirds of the alleged CIP deviations. The residual pricing errors are associated with the limits-to-arbitrage framework.

Oil Price Dynamics and Currency-Hedging Behavior

For Korea, a major crude oil importer, we document that after crude oil prices spike, cross-currency basis swap spreads tend to tighten as the propensity to currency-hedge rises.

Macro-Derivatives Nexus: New Drivers of Cross-Currency Basis Swap Spreads

Over the last decade, the derivatives market has witnessed a collapse of covered interest parity (CIP) which has unlocked a stream of arbitrage opportunities across currencies for investment managers. In this paper, we introduce two new factors --- inflation differential and relative economic performance --- as potential drivers of CIP deviations. Employing data on G10 currencies, we document a striking new evidence that higher inflation differential and improvement in relative economic performance drive CIP deviations wider and hence arbitrage profits higher for dollar investors. Our results are largely robust to different controls, sampling frequency, and consideration of alternative empirical specifications.

Interrelations among Cross-Currency Basis Swap Spreads: Pre- and Post-Crisis Analysis

Several studies have investigated the magnitude, drivers, and even reasons for the existence of cross-currency basis swap spreads. However, studies examining the interrelations among these spreads have surprisingly been lacking. In this article, we examine the linkages among nine major cross-currency swap spreads, emphasizing how crisis periods have impacted the long-run relationships and short-run dynamics. Our results show that the long-run relationships were slightly weakened after crisis, while the short-run linkages were generally strengthened. The influence of euro and Swiss cross-currency swaps on other European cross-currency swaps generally increased after the crisis period, where the Swiss cross-currency swap became much more influential on all European cross-currency swaps. Our findings are robust to alternative reordering of variables in our nine-variable VAR system, computation of generalized impulse response functions, and consideration of rolling variance decompositions.

CCR KVA Relief Through CVA: A Regression-Based Monte Carlo Approach

We present and examine, by example of a USD interest rate swap and a EUR/USD cross-currency basis swap, a regression-based Monte Carlo approach to counterparty credit default risk (CCR) capital and CCR capital valuation adjustment (KVA) calculations [assuming the standardized approach to counterparty credit risk for exposure-at-default (SA-CCR EAD) and the internal ratings-based (IRB) approach for CCR risk weights]. This approach allows to incorporate the capital lowering effect of credit valuation adjustment (CVA) in an efficient manner, without having to resort to lengthy nested Monte Carlo simulations. We find that the regression-based Monte Carlo approach works well in most situations. In other situations, the accuracy of the approach is sensitively controlled by the choice of explanatory variables. We discuss in detail the conditions and underlying dynamics under which this happens. In computing and presenting a selection of numerical examples, we also explore the impact of dynamic CCR risk weights on CCR KVA, and compare regression-based CCR KVA results with CCR KVA results from nested Monte Carlo, alternative frequently used CCR KVA simplifications, and standardized CVA KVA.

CCR KVA Relief Through CVA: A Regression-Based Monte Carlo Approach

We present and examine, by example of a USD interest rate swap and a EUR/USD cross-currency basis swap, a regression-based Monte Carlo approach to counterparty credit default risk (CCR) capital and CCR capital valuation adjustment (KVA) calculations [assuming the standardized approach to counterparty credit risk for exposure-at-default (SA-CCR EAD) and the internal ratings-based (IRB) approach for CCR risk weights]. This approach allows to incorporate the capital lowering effect of credit valuation adjustment (CVA) in an efficient manner, without having to resort to lengthy nested Monte Carlo simulations. We find that the regression-based Monte Carlo approach works well in most situations. In other situations, the accuracy of the approach is sensitively controlled by the choice of explanatory variables. We discuss in detail the conditions and underlying dynamics under which this happens. In computing and presenting a selection of numerical examples, we also explore the impact of dynamic CCR risk weights on CCR KVA, and compare regression-based CCR KVA results with CCR KVA results from nested Monte Carlo, alternative frequently used CCR KVA simplifications, and standardized CVA KVA.

Interrelations Among Cross-Currency Basis Swap Spreads: Pre-And Post-Crisis Analysis

We examine the long-run relationships and short-run dynamic linkages among 9 major cross-currency swap spreads, with specific emphasis on how crisis periods have impacted the long-run relationships and short-run dynamic transmissions. The results show that the long-run relationships were slightly weakened after the crisis, while the short-run dynamic linkages were generally strengthened. The influence of euro and swiss cross-currency swaps on other European cross-currency swaps generally increased after the crisis; the swiss cross-currency swap became several times more influential on all European cross-currency swaps. Our findings are robust to alternative reordering of the variables in our 9-variable VAR system, computation of generalized impulse response functions and consideration of rolling variance decompositions. Overall, our results can be summarized, as follows, in the spirit of Newton’s first law of motion: Post crisis, there is a reluctance for the cross-currency swaps to wander as the short-run linkages between them have strengthened. But when these links break (due, perhaps, to a system-wide shock), setting the swaps in motion, the swaps would be again reluctant to revert to their previous state of equilibrium because their speed of convergence has slowed, and hence their long-run relationships have weakened.