Why Cross-Currency Basis Swaps Persist Despite Interest Rate Parity
Summary
The document explains why a cross-currency basis, such as the cited euro–dollar spread, can persist even when interest rate parity suggests an arbitrage opportunity. One source is one-sided hedging demand: companies borrowing in one currency may swap their payments into another, creating pressure on the basis when flows are imbalanced.
The proposed arbitrage is constrained by who can access funding and by balance-sheet costs. Large banks may be able to borrow near benchmark interbank rates, but holding a multi-year swap position ties up capital for a relatively small return. Other investors may lack comparable funding access or need bank financing, which brings the same balance-sheet constraint back into the trade. The explanations are qualitative and do not quantify these costs or establish that every basis movement has the same cause; they show why frictionless parity arbitrage may fail in actual markets.
Key ideas
- One-sided corporate borrowing and currency-hedging flows can push a cross-currency basis away from zero.
- Banks may decline to arbitrage the spread when the position ties up balance sheet for years.
- Other investors may not be able to borrow at benchmark interbank rates or finance the trade economically.
- Interest rate parity does not guarantee that a basis can be arbitraged away under real funding constraints.
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# Cross Currency Basis Swap # Cross Currency Basis Swap I understand that there exist a cross Currency Basis between euro and dollar of about 35 bps, which in my understanding can be arbitraged out by following principle of interest rate parity. However, it still exists and has increased dramatically after change in NAV regulations for money market MFs in the US. Could somebody pls explain why Cross Currency Basis should exist in the world of complete capital mobility. Thanks ## Answer by Chris Taylor (score 4) https://quant.stackexchange.com/a/35327 To add to dm63's answer, I think there are a few reasons - - It's worth asking about why a cross-currency basis spread exists in the first place. The standard explanation is demand from (for example) Japanese corporates to issue fixed-rate debt in the US, where rates are generally higher, and swap the payments back into JPY with a cross-currency basis swap. This demand only goes one way, so it puts pressure on which pushes the basis away from zero. - Global investment banks, who are the market participants able to borrow and lend at closest to USD LIBOR or EURIBOR, would in the past absorb this flow, and arbitrage away any differences. But they are constrained by balance sheet considerations - arbitraging away a five year EUR/USD cross-currency basis swap spread requires deploying balance sheet for up to five years, for a return of only 35 basis points. Many banks don't think it is worth it. - Other market participants, e.g. hedge funds, can't generally borrow/lend at LIBOR or EURIBOR themselves, so the option may not be open to them. Even if it was, they generally don't have enough cash on hand to make it economically viable, so they would need to borrow from banks, who would need to deploy balance sheet to support the borrowing, and we have just seen that banks don't like to deploy balance sheet right now. ## Answer by dm63 (score 3) https://quant.stackexchange.com/a/35322 To give a short answer , it is very simple. Market participants cannot actually borrow and lend freely at USD Libor or Euribor. Hence the basis swap cannot easily be arbitraged away.
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