The Cross-Currency Basis
Covered interest parity says borrowing a currency directly and borrowing it synthetically through an FX swap should cost the same — the persistent gap between them, the cross-currency basis, is a real, tradeable signal of who can and can't get dollars.
Prerequisites: Covered Interest Parity, FX Swaps
Textbook theory says there should be exactly one cost to holding dollars: borrow them directly in the interbank market, or borrow euros and swap into dollars, and after fees the rate should come out the same either way — that's covered interest parity, and it's supposed to hold by pure arbitrage. Since the 2008 crisis it mostly hasn't. Swapping into dollars has been persistently more expensive than borrowing them outright, for banks that in theory could do either. That gap is the cross-currency basis, and it never fully closes.
The cross-currency basis is the extra cost of borrowing a currency synthetically through an FX swap versus borrowing it directly. In theory it should be zero. In practice it's usually negative for dollars against most other currencies, meaning everyone outside the US effectively pays a premium for dollar funding — a standing symptom of how scarce and how demanded dollars are outside their home market.
Where the number comes from
Rearranging covered interest parity to solve for the rate the swap market implies, and comparing it to the rate actually quoted in the cash market, gives the basis directly:
In words: take what it really costs a bank to borrow dollars in the money market, subtract what the FX swap market says dollars should cost given the euro rate and the forward points, and whatever is left over is the basis. A negative number means the swap-implied rate is higher than the direct rate — dollars are more expensive to get synthetically than to borrow outright, even though arbitrage should force them to the same number.
Worked example
The swap market implies a dollar funding rate of 4.84% for a European bank swapping euros into dollars (see the worked example on FX-swap-implied yields). That same bank can borrow dollars directly, unsecured, at 4.55%. The basis is , or "minus 29 basis points" in trader shorthand. In principle the bank should always borrow direct and ignore the swap market. In practice, balance-sheet limits, collateral rules, or simply not having enough unsecured credit lines to borrow $500 million outright mean many banks have to use the swap market anyway, paying the extra 29 basis points because it's the only channel open to them.
What this means in practice
The basis is watched as a real-time gauge of dollar funding stress: it barely moves in calm markets, then snaps sharply more negative in a crisis as banks scramble for dollars and balance-sheet capacity to intermediate the swap market dries up. Central banks respond to a blown-out basis by opening swap lines with the Federal Reserve, which lend dollars directly to foreign central banks and cap how expensive synthetic dollar funding can get.
A nonzero basis is not free money sitting on the table. The "arbitrage" that should close it requires balance sheet, and post-crisis capital rules make balance sheet expensive to use — so banks rationally leave the gap open rather than deploy scarce capacity to capture a few basis points.
Related concepts
Practice in interviews
Further reading
- BIS Quarterly Review, 'The Dollar-Trillion FX Swap Market'
- Du, Tepper & Verdelhan, 'Deviations from Covered Interest Rate Parity', Journal of Finance (2018)