12 March 2009 - No.

72 Evariste Lefeuvre

What basis swaps tell us about the need for dollars

The introduction of currency swap lines between central banks after the October 2008 crisis made it possible to dampen the pressure on short-term dollar financing. On the other hand, an analysis of 5-year cross currency basis swaps shows that the pressure on long-term dollar financing remains strong and have even become more marked over the last few months. We suggest a few explanatory factors of the steepening of the term structure of basis swap spreads.
The increase in the need for dollar financing in October/November 2008 went hand in hand with a drastic fall in the EUR/USD.
Dollar borrow ing needs
Implied EUR/USD FX-swap 3M rate vs 3M Libo r spread 3-mo nths change in EUR/USD - inv. Scale - RHS

Cross Currency Basis Sw ap Spreads (pb)

Do llar / Yen B asis Swap 5 years

20 -0,3 -0,2 -0,1 0,0 0,1 -80 0,2 97 98 0 -20 -40 -60

Do llar / Euro B asis Swap 5 years

20 0 -20 -40 -60

1,75 1,5 1,25 1 0,75 0,5 0,25 0 -0,25 07

Sources : Bloomberg, NATIXIS

-80 04 05 06 07 08

99

00

01

02 03

Sources : Bloomberg

0,3 08 09

The downturn in the EUR/USD has not been accompanied by a new wave of pressure on the FX-swaps market for several weeks. Institutional factors have often been mentioned to explain the recent weakness. Even so, need for dollar financing must be analysed based on longer maturities. In the following section we will describe in detail the trend in 5-year (cross currency) basis swaps in euros against dollars. A cross currency basis swap (BS in the following section) is an exchange of two floating rates in two different currencies, Libor in this case (and also in general). As these are floating interest rates, the two legs of the swap must always be valued at par and the BS spread must therefore be zero from an actuarial point of view. However, unlike numerous swaps, the basis swap contains an initial exchange of notional in each currency - hence a credit and liquidity risk. As a result, as can be seen in the Chart below, there is a generally low structural premium between the USD Libor leg (generally the reference against which the spread is measured) and the foreign currency leg (BS are quoted in foreign currency Libor + spread against USD Libor flat).

As an example, the USD Libor/JPY Libor basis swap spread was structurally negative in the 1990s, which reflected the deterioration in the creditworthiness of the banking system. There has also been a very marked deterioration in the euro/dollar basis swap since mid-2008. Furthermore, the spread between the 5-year BS and the 1-year BS has, for its part, changed direction over the last few weeks. The pressure on the short term, which was very strong during the Lehman Brothers bankruptcy, is now less pronounced than for longer maturities.
5-y vs 1-y basis sw aps spreads
Spread - rhs B S 5 years

20 0 -20 -40 -60 -80 -100 -120 -140 08

B S 1 year

120 100 80 60 40 20 0

Sources : Bloomberg, NATIXIS

-20 09
N 72 - 12 mars2009 I 1

What are the risks reflected by a negative basis swap spread? We can distinguish two types of factors likely to affect BS spreads. 1. Due to the nature of the flows exchanged, the risks included in the Libor (perception of banking and liquidity risk) are likely to affect the BS spread. As can be seen in the Chart below, there is, empirically, a spread over the entire term structure of basis swaps. This suggests for example, in the case of the yen, that to enter into a swap where he pays USD Libor flat, an investor will want to receive JPY Libor +/a spread (the basis).
Term structure of basis sw aps (vs US Libor flat) 20 10 0 -10 0 -20 -30 -40 -50 -60 Tenor 2 CAD 4 JPY 6 EUR 8 10

Basis sw ap and relative change of US libor / Euribor 3-m onths spread

1 -mo nth change o f libo r / euro bir 3-m spread - RHS

10 0 -10 -20 -30 -40 -50 -60 -70 06

B S 5 years

2,0 1,5 1,0 0,5 0,0 -0,5 -1,0 -1,5 -2,0 08 09

Sources : Bloomberg, NATIXIS

07

In this way, fluctuations in BS spreads also reflect 1 investors relative needs for such or such currency . If we go back to the illustration of dollar against yen BS, the BS spread may reflect the fact that ex ante demand for yen is low and that paying a substantial premium (the basis) is needed in order to balance the market. What about for the euro currently? The continuous widening in the BS spread in the last few months suggests that the premium demanded to exchange dollars against euros is very high, in particular in long maturities, which suggests that the supply of dollars remains very limited in these maturities. Conclusions: 1. The steepening in basis swap curves is largely explained by the easing seen in the interbank and FXswaps markets. The introduction of currency swaps between the Fed and several central banks has made it possible to normalise the tensions between supply and demand for dollars in short maturities. The transmission of this policy to the entire term structure of the cross currency basis swap curve has, on the other hand, proved to be very limited. 2. The widening of BS spreads in long maturities is above all the expression of a dollar scarcity effect.
FED: other Federal Reserves Assets (b USD)

This is explained by the fact that Libor rates are unsecured interest rates and therefore reflect - partially, in any case the credit risk on banks. As a result, it is possible that the BS spread may reflect this risk structurally (see the difference between the CAD BS - structurally positive - and the JPY BS) or cyclically (EUR today?). The credit risk is reflected in the fluctuations in Libor itself, as has been case for several quarters. These moves accounted for the sharp widening in the 1-year BS at end-2008. On the other hand, the very nature of long-term financing of BS longer than a year, makes the relation between pressure on Libor and fluctuations in BS much less evident empirically. On the Chart below we can clearly see that the relation between the fluctuation in the Libor spread and the trend in the 5-year BS is rather tenuous, especially if we focus on the October/November 2008 and February/March 2009 episodes. We must therefore look for other possible explanations. 2. Supply and demand. The spreads on BS reflect trends in supply and demand. If investors demand an additional spread on the Libor of the country in question, it is because the ex ante demand for the receiver of the currency (EUR, JPY) is low - or inversely that the appetite for the dollar is very substantial.

Spread

700 600 500 400 300 200 100 0

Sources : FED

700 600 500 400 300 200 100 0 04 05 06 07 08 09

http://www.bis.org/publ/qtrpdf/r_qt0903.pdf for a breakdown of banking institutions net needs for dollars. N 72 12 mars 2009 I 2