An arbitrage-based risk diagnostic of the cross-currency basis swap

Abstract

The cross-currency basis measures the yield differential between the single currency and cross-currency swap markets. The construction of discount curves for the purposes of pricing and risk-managing cross-currency cash flows necessarily incorporates this basis, resulting in a sensitivity to fluctuations in its value. The basis has proved prone to significant volatility twice in the last ten years. More recently, the credit crisis provoked a wave of fixed-income hedge fund de-leveraging which drove the basis to unprecedented levels. This paper derives a quasi-arbitrage pricing diagnostic with respect to the basis. This diagnostic is used to explain some of the empirical drivers of the US dollar–yen spread.