Analysing Cross-Currency Basis Spreads

29 Pages Posted: 18 Jul 2017

See all articles by Jaroslav Baran

Jaroslav Baran

European Stability Mechanism

Jiri Witzany

University of Economics in Prague

Date Written: July 18, 2017

Abstract

This paper investigates the drivers of cross-currency basis spreads, which were historically close to zero but have widened significantly since the start of the financial crisis. Credit and liquidity risk, as well as supply and demand have often been cited as general factors driving cross-currency basis spreads, however, these spreads may widen beyond what is normally explained by such variables. We suggest market proxies for EUR/USD basis swap spread drivers and build a multiple regression and cointegration model to explain their significance during three different historical periods of basis widening. The most important drivers of the cross-currency basis spreads appear to be short- and medium-term EU financial sector credit risk indicators, and to a slightly lesser extent, short- and medium-term US financial sector credit risk indicators. Another important driver is market volatility for the short-end basis spread, and the EUR/USD exchange rate for the medium term basis spread, and to a lesser extent, the Fed/ECB balance sheet ratio.

Keywords: Cross-currency swap, basis spread, overnight indexed swap, cointegration, arbitrage

JEL Classification: D53, G01, C31

Suggested Citation

Baran, Jaroslav and Witzany, Jiri, Analysing Cross-Currency Basis Spreads (July 18, 2017). European Stability Mechanism Working Paper No. 25. Available at SSRN: https://ssrn.com/abstract=3004731 or http://dx.doi.org/10.2139/ssrn.3004731

Jaroslav Baran (Contact Author)

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Jiri Witzany

University of Economics in Prague ( email )

Winston Churchilla Sq. 4
Prague 3, 130 67
Czech Republic

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