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

See all articles by Daniel Nathan

Daniel Nathan

Bank of Israel; University of Pennsylvania - Finance Department

Nadav Ben Zeev

Ben-Gurion University of the Negev - Department of Economics

Date Written: October 12, 2022

Abstract

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

Nathan, Daniel and Ben Zeev, Nadav, The Persistent Widening of Cross-Currency Basis: When Increased FX Swap Demand Meets a Shortage of Global Arbitrage Capital (October 12, 2022). Available at SSRN: https://ssrn.com/abstract=4246084 or http://dx.doi.org/10.2139/ssrn.4246084

Daniel Nathan (Contact Author)

Bank of Israel ( email )

P.O. Box 780
Jerusalem, 91907
Israel

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

Nadav Ben Zeev

Ben-Gurion University of the Negev - Department of Economics ( email )

Beer-Sheva 84105
Israel

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