Cross-Currency Basis

The cross-currency basis is the difference between the interest rate implied by borrowing a currency through the foreign-exchange swap market and the rate available for borrowing that currency directly in its own money market. It is quoted in basis points and is usually expressed against the US dollar. A negative dollar basis means that a non-US borrower who swaps its home currency into dollars pays more than the US dollar interest rate alone would suggest; dollars obtained through the swap market are dearer than they "should" be.

The basis is an important indicator of funding stress. Before 2008 it was close to zero for the major currencies. Since the global financial crisis it has stayed persistently non-zero, which economists treat as evidence that a textbook arbitrage no longer closes the gap.

The benchmark is covered interest parity. If the spot rate and the interest rates of two currencies are known, the fair price of a forward contract follows mechanically: the forward rate must offset the interest differential, otherwise a trader could borrow one currency, convert it, invest it, and lock in a riskless profit with a forward. That trade is a classic form of arbitrage.

An FX swap combines a spot exchange with a reverse forward exchange, so it is effectively a collateralized loan of one currency against another. When the forward points in the swap market differ from what covered interest parity implies, the difference is the basis. Longer maturities are traded as cross-currency basis swaps, in which two parties exchange floating-rate interest payments, now usually referenced to rates such as SOFR after the retirement of LIBOR, plus a spread on one leg. That spread is the quoted cross-currency basis. These instruments are related to, but distinct from, a plain interest rate swap, which involves only one currency.

Assume the euro-dollar spot rate is 1.1000, the one-year dollar rate is 5.00% and the one-year euro rate is 3.00%. Covered interest parity puts the one-year forward at 1.1000 × 1.05 / 1.03, or about 1.1214.

Suppose the market forward is instead 1.1240. A European bank that borrows €1,000,000 at 3%, converts it at spot into $1,100,000 and agrees to buy back €1,030,000 in a year at 1.1240 must deliver $1,157,720. Its effective dollar borrowing cost is therefore about 5.25%, roughly 25 basis points above the 5.00% direct dollar rate. That 25-point gap, quoted by convention as a basis of about minus 25 on the euro leg, is the cross-currency basis.

Several forces keep the basis away from zero:

• Structural dollar demand. Non-US banks, insurers and companies that fund dollar assets with home-currency liabilities hedge through swaps, creating steady one-way demand for dollars.
• Balance-sheet constraints. Post-2008 regulatory capital and leverage rules make the arbitrage costly for banks, so they no longer deploy unlimited capital to close small gaps. The effect is often visible around quarter-ends and year-ends.
• Counterparty and liquidity risk. In stress periods lenders hoard dollars, and the basis widens sharply.

The size of a position is measured by its notional amount, and even a few basis points on a large notional matter to treasurers and funding desks.

When the dollar basis has blown out, as in 2008 and again in March 2020, the US Federal Reserve has used central bank swap lines to lend dollars to foreign central banks, which on-lend them to their own banks. These operations have consistently narrowed the basis, confirming that it reflects dollar scarcity outside the United States. The Bank for International Settlements tracks the basis as a gauge of offshore dollar funding conditions, including the eurodollar market.

For practitioners the basis feeds into the true cost of hedging foreign investments, the pricing of currency swaps and the decision whether to fund in one currency or another. It also explains why a hedged foreign bond can yield more or less than interest rates alone suggest, and why moves in the federal funds rate do not translate one for one into offshore dollar costs.