The Persistent Widening of Cross-Currency Basis: When Increased FX Swap Demand Meets Limits of Arbitrage
59 Pages Posted: 19 Oct 2022 Last revised: 26 Jul 2023
Date Written: October 12, 2022
This paper examines customer demand-side factors that affect deviation from covered interest rate parity (CIP) with respect to the dollar (i.e., cross-currency basis), particularly when arbitrageurs are constrained. Using novel detailed daily transaction-level data on the universe of Israeli institutional investors (IIs), we employ a granular instrumental variable (GIV) estimation to investigate how IIs’ FX swap demand affects CIP deviation. Our findings demonstrate that a one standard deviation shock to IIs’ FX swap demand when capital is abundant has a null effect on IIs’ basis. However,
when capital is scarce, the demand shock produces significant and persistent reduction of 3.9-8.4 basis points in IIs’ basis, remaining significant for over 500 trading days.Our results, which are unchanged when we consider the complementary and popularized Bartik instrument approach instead of the GIV one, showcase how limits of arbitrage, together with demand shocks from a large customer base, can drive CIP deviations.
Keywords: LOA-Dependent FX Swap Demand Channel; Cross-Currency Basis; Open FX Swap Position; Limits of Arbitrage;Global Arbitrage Capital; Institutional Investors; Bayesian State-Dependent Local Projections
JEL Classification: E44, F3, G15, G23
Suggested Citation: Suggested Citation