Cross currency basis

What Is Cross Currency Basis?

The cross currency basis is the difference between the interest rate of borrowing a foreign currency through a foreign exchange market swap and the implied interest rate derived from interest rate parity. This spread, typically quoted in basis points, falls under the broader category of Foreign Exchange Markets and Derivatives. A non-zero cross currency basis indicates a deviation from covered interest rate parity, suggesting inefficiencies or funding premiums in global financial markets. It reflects the additional cost or benefit of borrowing in one currency by swapping another, rather than borrowing directly in the target currency. The cross currency basis is influenced by factors such as funding liquidity, credit risk, and regulatory changes, signaling the perceived ease or difficulty of obtaining a specific currency. It also encapsulates elements of counterparty risk in the underlying foreign currency swap transactions.

History and Origin

For decades prior to the 2008 global financial crisis, covered interest rate parity was widely considered to hold, meaning the cross currency basis was negligible, hovering close to zero. The belief was that any deviation would be quickly eliminated by arbitrageurs seeking risk-free profits. However, the crisis marked a significant turning point. Global dollar funding markets experienced severe strains as banks became reluctant to lend to one another, particularly across borders. This increased the cost of obtaining dollars for non-U.S. banks, leading to a persistent and often negative cross currency basis, especially against the U.S. dollar. This phenomenon indicated that it became more expensive to synthesize dollar funding via the foreign exchange swap market than to borrow dollars directly, challenging the long-held assumption of covered interest rate parity. Economists and market participants were compelled to re-evaluate the drivers of this basis, noting that factors beyond simple interest rate differentials, such as bank balance sheet constraints, regulatory costs, and perceptions of funding liquidity, were at play. The Federal Reserve Bank of New York has published extensively on this topic, seeking to explain the underlying mechanics of this market phenomenon.⁶

Key Takeaways

The cross currency basis measures the deviation from covered interest rate parity, reflecting the cost of obtaining one currency by swapping another.
A negative cross currency basis for a foreign currency against the U.S. dollar implies that it is more expensive for foreign entities to acquire dollars through FX swaps than via direct dollar borrowing.
The basis widened significantly during the 2008 global financial crisis and has persisted, influenced by factors like bank balance sheet capacity and regulatory changes.
It serves as a key indicator of liquidity and stress in global funding markets.
The cross currency basis can present arbitrage opportunities for sophisticated participants, though these are often limited by market frictions and capital constraints.

Formula and Calculation

The cross currency basis is fundamentally a deviation from the theoretical relationship defined by covered interest rate parity. While it's not a single, universally applied formula that generates the basis, it is observed as the difference between the implied interest rate from a foreign currency swap and the actual money market interest rate in that foreign currency.

Conceptually, covered interest rate parity suggests that the cost of borrowing in one currency and swapping it into another for investment should yield the same return as directly investing in the second currency, assuming no arbitrage opportunities. This can be expressed as:

\frac{F}{S} = \frac{1 + i_D \cdot (T/360)}{1 + i_F \cdot (T/360)}

Where:

(F) = Forward exchange rate
(S) = Spot rate
(i_D) = Domestic interest rate
(i_F) = Foreign interest rate
(T) = Tenor (days to maturity)

The cross currency basis arises when this equality does not hold. It represents the spread, typically in basis points, that needs to be added to or subtracted from one side of this equation to bring it back into equilibrium. For example, if it's more expensive to obtain U.S. dollars via a currency swap than through direct borrowing, the U.S. dollar cross currency basis would be negative.

Market participants often quote the basis directly as a spread over a benchmark interest rate (e.g., U.S. dollar LIBOR or SOFR) in the context of cross currency swaps.

Interpreting the Cross Currency Basis

The interpretation of the cross currency basis provides critical insights into the dynamics of global foreign exchange markets and funding conditions. A zero basis implies that covered interest rate parity holds, and there is no premium or discount for obtaining a currency via the swap market versus its domestic money market.

However, a non-zero basis indicates market dislocations. A negative cross currency basis for a foreign currency against a reference currency (most commonly the U.S. dollar) means that it is more expensive to borrow the reference currency (e.g., USD) through a foreign currency swap than to borrow it directly in its home market. This often points to high demand for the reference currency or perceived scarcity of its funding liquidity outside its home jurisdiction. Conversely, a positive basis would imply a cheaper cost of borrowing the reference currency via the swap market.

The magnitude and direction of the cross currency basis can serve as a barometer for market stress and risk perception. During periods of heightened uncertainty, such as the 2008 global financial crisis, the U.S. dollar cross currency basis became significantly negative as non-U.S. financial institutions faced increased difficulty and cost in accessing dollar funding. This negative basis reflected increased counterparty risk and liquidity premiums.

Hypothetical Example

Consider a hypothetical scenario involving the Japanese Yen (JPY) and the U.S. Dollar (USD) with a one-year tenor.

Spot Rate (USD/JPY): 150.00 (meaning 1 USD = 150.00 JPY)
One-Year JPY Interest Rate: 0.50%
One-Year USD Interest Rate: 5.00%

According to covered interest rate parity, the theoretical one-year forward rate (F) should be:

[
F = S \times \frac{1 + i_{USD}}{1 + i_{JPY}} = 150.00 \times \frac{1 + 0.0500}{1 + 0.0050} = 150.00 \times \frac{1.0500}{1.0050} \approx 157.0149
]

Now, suppose the actual one-year forward rate observed in the market is 157.50. This means the actual cost of swapping JPY for USD in the future is different from what parity suggests.

To calculate the cross currency basis, we can look at the implied USD interest rate from the foreign currency swap if one were to borrow JPY, swap to USD at spot, invest USD, and then swap back at forward.

The market forward rate (157.50) is higher than the theoretical forward rate (157.0149). This implies that borrowing USD via the FX swap market is more expensive than direct USD borrowing. The difference constitutes the cross currency basis.

In this case, the market suggests a higher implied USD interest rate when synthesizing USD funding through a JPY swap. This deviation would be expressed as a negative cross currency basis for JPY against USD, indicating a premium for dollar funding in the swap market.

Practical Applications

The cross currency basis is a crucial metric for a variety of participants in global financial markets:

Corporate Hedging and Funding: Multinational corporations use cross currency swaps to hedging currency risk and manage their funding costs across different currencies. The cross currency basis directly impacts the effective cost of such cross-border borrowing or lending.
Bank Balance Sheet Management: Banks, especially those with significant international operations, actively manage their currency exposures and funding profiles. A widening cross currency basis can signal increased costs for balance sheet constrained banks to engage in arbitrage that would typically push the basis back to zero.
Central Bank Operations: Central banks closely monitor the cross currency basis, particularly the U.S. dollar basis, as an indicator of liquidity strains in global funding markets. During times of stress, such as the 2008 financial crisis or the COVID-19 pandemic, the Federal Reserve established U.S. dollar liquidity swap lines with other central banks to alleviate these pressures and stabilize global financial conditions.⁵,⁴ These swap lines provide foreign central banks with access to U.S. dollars, which they can then lend to domestic institutions facing dollar funding shortages, directly impacting the cross currency basis by improving dollar funding liquidity.
Investment and Arbitrage Strategies: While perfect arbitrage opportunities are rare due to market frictions and regulatory costs, sophisticated investors and hedge funds might engage in basis trading. This involves taking positions to profit from expected convergence of the basis back to zero or from relative value plays between different currency pairs. However, such strategies are subject to liquidity and counterparty risk.
Economic Analysis: The cross currency basis provides valuable information about global financial interconnectedness and potential vulnerabilities. Persistent deviations can indicate structural shifts in funding markets or heightened risk aversion.

Limitations and Criticisms

While the cross currency basis offers valuable insights, its interpretation comes with certain limitations and challenges:

Complexity of Drivers: The cross currency basis is influenced by a multitude of factors, making it challenging to isolate the primary driver at any given time. These factors include funding liquidity, counterparty risk premiums, regulatory costs (such as capital requirements for banks), demand for specific currencies for hedging purposes, and even monetary policy divergence between countries. As such, interpreting a widening or narrowing basis requires careful consideration of the prevailing market environment.³
Limits to Arbitrage: The theoretical concept of arbitrage ensures that deviations from parity should be quickly eliminated. However, in practice, "limits to arbitrage" exist. These limits, including balance sheet constraints of arbitrageurs, higher funding costs, and regulatory capital charges for banks, can prevent the cross currency basis from reverting to zero. This means that seemingly risk-free profit opportunities may not be fully exploited due to practical impediments.² The Harvard Law School Forum on Corporate Governance has explored how these limits to arbitrage relate to global liquidity.¹
Market Frictions: Transaction costs, bid-ask spreads, and market depth can also contribute to a persistent, albeit small, cross currency basis. These frictions make it unprofitable to execute arbitrage strategies for very small deviations.
Behavioral Factors: During periods of extreme stress or uncertainty, market participants' flight-to-safety behavior can exacerbate dollar shortages and significantly widen the cross currency basis, as seen during the 2008 global financial crisis. Such dislocations are not purely driven by fundamental economic factors but also by panic and systemic risk perceptions.

Cross Currency Basis vs. Interest Rate Parity

The distinction between cross currency basis and interest rate parity is fundamental to understanding global foreign exchange markets.

Interest rate parity is a theoretical concept that posits a no-arbitrage relationship between interest rates and exchange rates. Specifically, covered interest rate parity suggests that the difference in interest rates between two countries should be equal to the difference between the spot rate and forward rate of their currencies. In a perfectly efficient market with no frictions, if covered interest rate parity holds, there would be no risk-free profit opportunity from borrowing in one currency, converting it to another, investing it, and simultaneously entering into a forward contract to convert it back.

The cross currency basis, on the other hand, is the observed deviation from this theoretical interest rate parity condition. When the cross currency basis is non-zero, it means that covered interest rate parity is not holding. This deviation represents an additional cost or premium for converting funds from one currency to another via the foreign currency swap market, above or below what interest rate differentials alone would imply. Confusion often arises because the basis is a direct measure of the breakdown of what was once considered a robust financial "law." Its existence and persistence, particularly since the 2008 financial crisis, signify structural changes and limitations within the international financial system.

FAQs

What does a negative cross currency basis mean?

A negative cross currency basis for a foreign currency against the U.S. dollar typically means that it is more expensive for a foreign entity to obtain U.S. dollars through a foreign currency swap than to borrow dollars directly in the U.S. money market. This often indicates a higher demand for U.S. dollars outside the U.S., or a perceived scarcity of dollar funding liquidity in international markets.

Why did cross currency basis become prominent after the 2008 financial crisis?

Before the 2008 financial crisis, the cross currency basis was usually negligible, as arbitrageurs quickly eliminated any deviations from interest rate parity. However, during the crisis, a scarcity of U.S. dollar funding outside the U.S., coupled with increased counterparty risk and bank balance sheet constraints, made it difficult for financial institutions to conduct the arbitrage necessary to bring the basis back to zero. This led to persistent non-zero deviations.

Is cross currency basis a measure of risk?

Yes, the cross currency basis can be a significant indicator of risk, particularly funding liquidity risk and systemic stress in global financial markets. A widening negative basis often signals increased perceived risk or scarcity of a particular currency, reflecting a higher cost for financial institutions to access that currency. It also incorporates elements of counterparty risk among market participants.

Who uses cross currency basis?

Participants who actively use or monitor the cross currency basis include large international banks, multinational corporations engaged in cross-border funding and hedging, institutional investors, and central banks. These entities use it to assess funding costs, manage currency exposures, and gauge the overall health and liquidity of global money markets.