Macro-Derivatives Nexus: New Drivers of Cross-Currency Basis Swap Spreads

Abstract

Over the last decade, the derivatives market has witnessed a collapse of covered interest parity (CIP) which has unlocked a stream of arbitrage opportunities across currencies for investment managers. In this paper, we introduce two new factors --- inflation differential and relative economic performance --- as potential drivers of CIP deviations. Employing data on G10 currencies, we document a striking new evidence that higher inflation differential and improvement in relative economic performance drive CIP deviations wider and hence arbitrage profits higher for dollar investors. Our results are largely robust to different controls, sampling frequency, and consideration of alternative empirical specifications.

Keywords: cross-currency basis, inflation differential, economic performance

JEL Classification: E1, F3, G1