The Persistent Widening of Cross-Currency Basis: When Increased FX Swap Demand Meets a Shortage of Global Arbitrage Capital
45 Pages Posted: 19 Oct 2022 Last revised: 27 Oct 2022
Date Written: October 12, 2022
Recent research has documented and studied a persistent widening of cross-currency basis (i.e., deviation from covered interest rate parity) for a wide range of currencies with respect to the dollar since the global financial crisis. Theory of the foreign exchange (FX) swap market predicts that shortage of global arbitrage capital (GAC), by making the FX swap supply curve less elastic, would amplify the effect of increases in institutional investors’ (IIs’) demand for FX swaps on cross-currency basis. We use novel daily data on Israeli IIs’ and global banks’ FX swap flows to test this prediction within a suitable Bayesian local projection model, finding strong evidence supporting a meaningful and persistent such amplification mechanism.
Keywords: GAC-Dependent FX Swap Demand Channel; Cross-Currency Basis; Open FX Swap Position; Global Arbitrage Capital; Institutional Investors; Bayesian State-Dependent Local Projections
JEL Classification: E44, F3, G15, G23
Suggested Citation: Suggested Citation