Explanation:
A non-zero FX swap basis indicates a deviation from covered interest parity (CIP). Arbitrageurs would theoretically eliminate this basis, but due to limits to arbitrage (e.g., regulatory capital constraints and balance sheet costs), they demand a premium. Consequently, they pass on their balance sheet borrowing costs into the forward FX swap prices, sustaining the non-zero basis. Options B, C, and D describe mechanisms that might impact supply and demand for foreign currency but do not directly account for the persistence of a positive swap basis due to limits to arbitrage constraints in the way balance sheet costs do.
A
A positive FX swap basis may exist because arbitrageurs pass on their balance sheet borrowing costs through the forward FX swap price.
B
A persistent and positive FX swap basis is likely to result from non-financial firms issuing debt denominated in their home currency in offshore capital markets rather than in their home country’s debt market.
C
A persistent and positive FX swap basis may exist because of the decision of institutional investors to reduce their hedges of foreign currency investments.
D
A persistent and positive FX swap basis is likely to result from international banks concentrating their lending activities in their home markets and reducing loan exposures in offshore markets.
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