Cross-Currency Basis

The cross currency basis is the extra spread that must be added to one leg of a currency swap to make it fair at market prices. In a world where covered interest parity held perfectly, the basis would be zero. Since the 2008 financial crisis, it has often been significantly negative for many currencies against the US dollar, meaning that borrowing dollars through currency swaps costs more than interest rate differences alone suggest. The basis has become an important gauge of global dollar funding stress.

Definition#

In a cross currency basis swap, one party pays a floating rate in one currency and receives a floating rate in another, plus a spread (the basis) on the non dollar leg.

• Negative basis (e.g. EUR/USD minus 20 basis points): the party borrowing dollars via the swap effectively pays 20 basis points more than parity implies. Dollars are in demand.
• Positive basis: the reverse.

Equivalently, the basis shows up as a gap between the dollar interest rate implied by FX forwards and the actual dollar money market rate. See FX Swaps and Currency Swaps and Covered and Uncovered Interest Parity.

Why the basis exists#

If covered interest arbitrage were free and could be done at any size, any basis would be traded away. After 2008, several frictions prevent this:

Research by economists at the BIS and others, including Du, Tepper and Verdelhan (2018), documented persistent CIP deviations and linked them to bank balance sheet constraints, with spikes around quarter ends.

When the basis widens#

• Financial crises: in late 2008, the basis for several currencies against the dollar widened to well over 100 basis points as banks scrambled for dollars.
• March 2020: the basis widened sharply as global firms hoarded dollars, until the Federal Reserve expanded central bank swap lines. See The Federal Reserve and the FOMC.
• Quarter and year ends: banks shrink balance sheets, temporarily widening short dated basis.
• Strong hedging demand: for example, Japanese investors hedging large US bond holdings push the USD/JPY basis more negative.

Why it matters#

See Systemic Risk.

Basis and hedged returns#

When the basis is negative for a foreign investor buying US assets, hedging the dollar exposure back to their home currency is more expensive than interest differences alone. A Japanese insurer buying US Treasuries may find that, after hedging costs including the basis, the hedged yield is barely higher than Japanese government bonds, which affects global capital flows.

Frequently asked questions#

What is the cross currency basis?#

The spread added to one leg of a currency swap to make it fair at market prices, reflecting deviations from covered interest parity.

Why is the cross currency basis negative?#

Mainly because of strong demand for dollar funding and limits on banks' ability to arbitrage, which make borrowing dollars via swaps more expensive than parity implies.

What does a widening basis signal?#

Stress in dollar funding markets, often during crises or around quarter ends.

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