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

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.