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The widening of cross-currency basis: When increased FX swap demand meets limits of arbitrage

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  • Ben Zeev, Nadav
  • Nathan, Daniel

Abstract

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 no effect on IIs’ basis. However, when capital is scarce, the demand shock produces a significant reduction of 12 basis points in IIs’ basis. Our results showcase how limits of arbitrage, together with demand shocks from a large customer base, can drive CIP deviations.

Suggested Citation

  • Ben Zeev, Nadav & Nathan, Daniel, 2024. "The widening of cross-currency basis: When increased FX swap demand meets limits of arbitrage," Journal of International Economics, Elsevier, vol. 152(C).
    • Handle: RePEc:eee:inecon:v:152:y:2024:i:c:s0022199624001119
    DOI: 10.1016/j.jinteco.2024.103984
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    More about this item

    Keywords

    LOA-dependent FX swap demand channel; Cross-currency basis; Limits of arbitrage; Granular instrumental variable; Bartik instrument; Open FX swap position; Institutional investors;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F3 - International Economics - - International Finance
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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