Cross-Currency Basis¶
One-line definition¶
The gap between the actual market FX forward and the forward implied by pure covered interest parity — the market's deviation from the textbook no-arbitrage relationship.
Formula¶
Solve for the foreign rate that CIP would need to reproduce the observed market forward, then subtract the actual foreign rate:
implied_foreign_rate = ((1 + r_domestic*T) * S / F_market - 1) / T
basis = implied_foreign_rate - r_foreign
Why PMs care¶
In theory, CIP should hold exactly (it's a static no-arbitrage relation). In practice, funding constraints, balance-sheet costs, and demand for dollar funding make cross-currency basis persistently nonzero — a PM using cross-currency swaps to fund or hedge foreign assets pays or earns this basis on top of the rate differential.
Common mistakes¶
- assuming CIP holds exactly and pricing a hedge without the basis
- treating basis as free money without accounting for the balance-sheet and counterparty costs of the trade that generates it