Covered Interest Parity in Cross-Currency Swap Bases and Demand for US Treasuries

This paper studies the dynamic relationship between demand for the US Treasury yields and cross-currency swap (CCS) bases since the 2008 global financial crisis. Using a three-factor non-Gaussian-term structure model for the US Treasuries, an estimated short-rate premium in the yield curve tends to move in tandem with and lead the euro and Japanese yen CCS bases against the US dollar. The dynamics between the premium and CCS bases are found to be co-integrated, suggesting a long-run equilibrium between them. Empirically, the premium is found to be positively related to demand for Treasuries. This is consistent with recent studies in which factors including the strength of the US dollar, the demand for dollar funding and banks’ balance-sheet structures play important roles in determining the CCS bases. These factors increase demand for US Treasuries (high-quality US dollar assets) by investors searching for safe dollar assets and banks with higher leverages due to increased demand for dollar funding. The findings in this paper contribute to explaining the widespread failure of covered interest parity in foreign exchange swap markets.