The Dollar Funding Premium and the FX Swap Basis
Borrowing dollars synthetically through the FX swap market should cost the same as borrowing dollars directly, by covered interest parity — but it persistently doesn't, and that gap, the cross-currency basis, is a standing tax on anyone outside the US who needs dollars.
Prerequisites: FX-Swap-Implied Yields and Synthetic Funding, Central Bank Swap Lines and Dollar Funding
Covered interest parity says that borrowing dollars synthetically — post euros, receive dollars via an FX swap, pay implied dollar interest through the swap points — should cost exactly the same as borrowing dollars directly in the cash market. If it didn't, arbitrageurs would exploit the gap until it closed. Since the 2008 crisis, that gap has not closed. It has become a persistent, structural feature of global funding markets, known as the cross-currency basis or, from the borrower's side, the dollar funding premium.
The dollar funding premium is the extra cost, above what covered interest parity predicts, that non-US banks pay to obtain dollars through the FX swap market. It persists because the arbitrage that should erase it requires balance sheet that regulatory capital rules make expensive to deploy — so the "free lunch" sits there because almost nobody can actually eat it.
Why the arbitrage doesn't get arbitraged away
Exploiting the gap would mean a bank borrowing euros cheaply, swapping into dollars, lending those dollars out or depositing them, and swapping back — a trade that in a frictionless world requires no capital, just balance sheet to book both legs. Post-crisis leverage-ratio rules changed that: every leg of the trade, even a fully collateralized, near-riskless one, adds to the balance-sheet measure banks are constrained on. Deploying scarce balance sheet on a low-margin arbitrage competes with every other, higher-margin use of that same balance sheet. Banks require enough of a spread to make it worth their while, and because dollar demand from the rest of the world persistently exceeds what the swap market can supply near parity, that required spread survives as a standing cost rather than getting competed to zero.
Worked example
A European bank finds its direct, unsecured dollar borrowing cost is 4.60%. Sourcing the same dollars synthetically through the FX swap market implies a cost of 4.84% (see FX-swap-implied yields). If it needs $500 million for three months and can only actually access the swap channel — because balance-sheet limits or a shortage of direct dollar lenders willing to deal with it in size mean the "cheaper" direct route isn't really available — it pays , i.e. $300,000 more over the quarter than covered interest parity alone would predict.
What this means in practice
The basis widens sharply at quarter-ends (when balance-sheet constraints bite hardest) and during genuine dollar funding crises, which is exactly why central bank swap lines exist: by letting foreign central banks auction dollars directly to their own banks, swap lines give banks a channel that bypasses the constrained FX swap market entirely, which is one of the few tools shown to reliably narrow the basis during stress.
Seeing a persistent cross-currency basis does not mean there is uncaptured arbitrage profit sitting in the market. It means the capital required to capture it costs more than the basis itself — treating it as "free money" is the single most common misunderstanding of this market.
Related concepts
Practice in interviews
Further reading
- Du, Tepper & Verdelhan, 'Deviations from Covered Interest Rate Parity'
- BIS Quarterly Review, 'The Dollar Shortage in Global Banking'