Equilibrium in FX Swap Markets: Funding Pressures and the Cross-Currency Basis

Jean-Marc Bottazzi, Jaime Luque and Mario Pascoa
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Jean-Marc Bottazzi: Capula and Paris School of Economics
Jaime Luque: University of Wisconsin - Madison
Mario Pascoa: University of Surrey

No 517, School of Economics Discussion Papers from School of Economics, University of Surrey

Abstract: To understand this normality requires turning the CIP logic on its head. We look at the Foreign Exchange (FX) swap market as the very market where scarce funding capacities are exchanged; the basis becomes an equilibrium outcome that compensates one of the parties for the temporary loss in the possession of one of the currencies. Ultimately, the counterparty’s funding pressure in that currency determines the willingness to pay for such endogenous possession value. In our model, banks compete for funding in two currencies. Unsecured, secured and FX positions are bounded by leverage ratio constraints tying banks’ equity. Currency-specific funding pressures are apparent in banks’ secured funding constraints, governing how securities denominated in different currencies can be pledged (and short-sold). The latter, not the former, is what drives the basis; this explains why bases also arise with no crisis in sight. A basis occurs when secured funding becomes more binding in one currency than in the other; leverage constraints can only have an accessory effect through this channel. Equivalently, the basis depends on how different across currencies are the spreads between actual (bank specific) unsecured borrowing rates and the secured rates. To illustrate, we look at central banks’ actions targeting international funding pressures, in particular FX swaps lines and collateral policies.

JEL-codes: D5 E5 G15 G18 (search for similar items in EconPapers)
Pages: 61 pages
Date: 2017-03
New Economics Papers: this item is included in nep-ifn and nep-mac
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Citations: View citations in EconPapers (1)

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