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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

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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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  • $\begingroup$ thanks for your reply. But that's precisely my question. The global banks that have access to both Euro and Dollar market should be able to drive out this arbitrage. But it still exists $\endgroup$
    – Kunal Jain
    Jul 28 '17 at 0:08
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To add to dm63's answer, I think there are a few reasons -

  1. 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.

  2. 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.

  3. 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.

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  • $\begingroup$ Thanks for such detailed explanation Taylor. This makes a lot of sense now. To conclude, there is an arbitrage in the form of cross currency basis, however due to other constraints that you mentioned like balance sheet etc banks are not able to make use of this opportunity. $\endgroup$
    – Kunal Jain
    Jul 28 '17 at 15:25
  • $\begingroup$ Yes. If you google "limits to arbitrage" you will find plenty of related reading. $\endgroup$
    – Chris Taylor
    Jul 29 '17 at 18:21

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