What is the cross-currency basis?

DM

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Technically speaking, the cross-currency basis is the difference in the cost of hedging an FX risk and the interest rate differential between the two currency areas, i.e. it measures deviations from covered interest parity (CIP). The CIP theory postulates that the cost of hedging a foreign currency risk should be the same as the difference in the local and foreign interest rates. Otherwise, it would be possible to borrow at the lower interest rate and lend at the higher interest rate with currency risk fully hedged, thereby earning a riskless profit. CIP is a no-arbitrage theory: It says that market participants will take advantage of inefficiencies in market prices until risk-free returns are no longer possible.

Until few years ago the CIP relationship held surprisingly well. Most academic studies found only very small deviations from CIP theory, which were mostly explained by transaction costs. Even papers looking into high-frequency trading found only short-lived deviations, suggesting that the market was highly efficient indeed: The cross-currency basis had been close to zero for a long period of time.

All that changed after the financial crisis of 2007-09: Since early-2008, the cross-currency basis for swapping a currency into US dollars has been far more volatile than before. There were significant negative spikes from 0 to -40 basis points in 2008-09, followed by a recovery in 2010 and another steep drop to -45bps in 2011. From 2014 to 2017 the basis was on a steady downward path again. There have also been large swings within the calendar year, e.g. the basis tended to turn more negative at the end of a quarter and especially in December when many hedging transactions needed to be rolled over.

It is market standard that the cross-currency basis be quoted in basis points such that it indicates by how much the non-US interest rate would have to be adjusted for the CIP deviation to hold again. For example: If the EUR/USD basis is at -50bps, as was the case in late-2016, that suggests the euro money market rate would have to fall by 50 basis points for the CIP violation to vanish. In other words, the cost of hedging a USD currency risk from the perspective of an investor based in the euro area was 50 basis points greater than the premium she could have collected in the US money market.

But what causes the cross-currency basis to move away from zero? The basis is an indicator of the supply of and demand for US dollars, and it is striking to see the strong correlation between USD exchange rates and the different cross-currency bases, implying that USD strength comes at a cost for investors looking to hedge their USD exposures. There must be other structural factors at play, however: Could it be that banks are more restricted in their ability to lend US dollars due to new regulations after the crisis? What else has changed since 2008? I will look into possible drivers of the cross-currency basis in another post here on CurrencyManagers.com. Stay tuned.
 
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