The Link between FX Swaps and Currency Strength during the Credit Crisis of 2007-2008

Abstract

This note analyses the impact of the global credit crisis on the FX swap market and discusses its potential implications. The turbulence in money markets has spilled over to FX swap markets amid a reappraisal of counterparty risks during the recent financial turmoil. We examine the situations of six currencies including the euro, the British pound, the Australian dollar, the Japanese yen, the Hong Kong dollar and the Singapore dollar. We find that (i) the risk premiums have indeed gone in tandem with the spreads of money market rates over their corresponding overnight index swaps across the economies, a popular measure of potential banking insolvency; and (ii) the risk premiums bear a negative relationship with the strength of the spot rates of the respective currencies, which is consistent with the increased pressure in the swap markets.

Keywords: FX swaps, covered interest parity, counterparty risk

JEL Classification: F31, G15