From CIP-deviations to a market for risk premia: a dynamic investigation of cross-currency basis swaps

The persistent deviations from the covered interest rate parity (CIP) since 2007 indicate that specific frictions continue to exist, which prevent them from being arbitraged away. In this study, we study the cross-currency basis swap market and put forward the argument that the risk premium expressed via the CIP-deviation constitutes a unique market that determines its own equilibrium price after receiving feedback from various sources, including contagion within the market itself. We investigate contagion using a TVP-VAR framework of analysis that measures the extent of connectedness across the bases on all G10 currencies against the US dollar between 2007 and 2018. Our main findings indicate that connectedness is event-dependent. Furthermore, we provide evidence that net-transmitting bases are typically associated with safe haven currencies (e.g. CHF) and banking sectors with significant overseas operations (e.g. EUR and JPY). On a pairwise level, results confirm that during tranquil times in international financial markets, connectedness subdues and even reaches negligible levels - particularly for stable banking systems (e.g. CAD) or without significant US dollar funding gaps (e.g. AUD).