Research Note 01/2009

10 February 2009

THE LINK BETWEEN FX SWAPS AND CURRENCY STRENGTH DURING

THE CREDIT CRISIS OF 2007-2008

Prepared by Hans Genberg, Cho-Hoi Hui, Alfred Wong and Tsz-Kin Chung
Research Department

Abstract

This note analyses the impact of the global credit crisis on the FX swap market and
discusses its potential implications. The turbulence in money markets has spilled over to
FX swap markets amid a reappraisal of counterparty risks during the recent financial
turmoil. We examine the situations of six currencies including the euro, the British
pound, the Australian dollar, the Japanese yen, the Hong Kong dollar and the Singapore
dollar. We find that (i) the risk premiums have indeed gone in tandem with the spreads
of money market rates over their corresponding overnight index swaps across the
economies, a popular measure of potential banking insolvency; and (ii) the risk premiums
bear a negative relationship with the strength of the spot rates of the respective currencies,
which is consistent with the increased pressure in the swap markets.

JEL classification: F31; G15

Key words: FX swaps; covered interest parity; counterparty risk

Author’s E-Mail Address:

genberg@hkma.gov.hk; chhui@hkma.gov.hk; alfred_yt_wong@hkma.gov.hk;
btkchung@hkma.gov.hk

The views and analysis expressed in this paper are those of the authors, and do not
necessarily represent the views of the Hong Kong Monetary Authority.

Electronic copy available at: http://ssrn.com/abstract=1340280

 -2-

I. INTRODUCTION

The abrupt escalation of the recent global credit crisis last September
marked an important turning point for many currencies. Those that had exhibited
remarkable strength in the recent past (e.g., the British pound, the euro, the Australia dollar)
depreciated abruptly, while others (e.g., the Japanese yen, the Hong Kong dollar) rallied
strongly. At the same time, unusual pricing behaviour occurred in the foreign exchange
(FX) swap market, revealing significant and persistent departure from covered interest
parity, a well-established and well-tested theory in international finance. What messages
are these atypical phenomena sending us? This note attempts to shed light on these
questions by looking at the FX swap market more closely and finding that the two
phenomena appear to be linked.

II. COVERED INTEREST PARITY IN FINANCIAL TURMOIL

The interest parity theory states that the equilibrium forward exchange rate
F is:
S (1 + r )
F= , (1)
(1 + q )
where S is the spot exchange rate (the domestic currency value of a unit of the US dollar),
r and q are, respectively, the domestic and the US dollar rates of interest on securities that
identical in all respects except for the currency of denomination. The market forward
exchange rate F* gives a swap-implied US dollar interest rate q*. Therefore, the return
of investing a sum of money in a domestic interest-bearing asset for a certain period of
time is the same as the return of investing in a similar foreign interest-bearing asset by
converting the sum into a foreign currency while simultaneously purchasing a futures
contract to convert the investment back at the end of the period. If the returns are
different, an arbitrage transaction could, in theory, produce a risk-free return.

It is important to note that covered interest parity assumes that

assets denominated in domestic and foreign currency are freely traded internationally
(i.e., no capital controls) and have negligible transaction costs and similar risks. Given
today’s technology, these assumptions normally hold in the international financial markets,
and so the parity condition is observed almost all the time (except for those countries
where capital controls are still in place). However, there are times and situations in
which the condition breaks down. Taylor (1989) finds that during the floating of the
sterling in 1972 and the inception of the European Monetary System in 1979, significant
departure had occurred from covered interest parity for periods long enough to challenge
the theory.1

1
Other studies have attempted to rationalise these departures in terms of transactions costs, e.g., Frenkel
and Levich (1977) and Clinton (1988).

Electronic copy available at: http://ssrn.com/abstract=1340280

 -3-

One of the possibilities is that in times of financial turmoil, true risks,

or risks as perceived by market participants, might have changed, rendering the
assumptions of covered interest parity inapplicable. Indeed, a recent BIS study by Baba
and Packer (2008) finds that in the recent global financial crisis the turbulence in money
markets has spilled over to FX swap markets amid a reappraisal of counterparty risks.2
The spillover occurred, as European banks needed to secure US dollar funding to support
their US conduits, while US banks – also facing increased financing difficulties and
having to preserve funds on hand – became cautious in lending to their European
counterparts, forcing the latter to resort to converting euros into dollars in the swap market.
As soon as European banks (borrowers), perhaps with the exception of the well-known
members on the LIBOR panel, were perceived to be riskier by US banks (lenders), a risk
premium quickly developed, adding to the dollar funding rates in the swap.

In Chart 1, the green line measures how much the implied 12-month US
dollar funding rate deviates from the corresponding LIBOR – the risk premium demanded
by dollar lenders in the swap market or the departure from covered interest parity.3,4
As can be seen, before the summer 2007 it oscillated around 0% but after that it had
followed an upward trend. And from around the beginning of September 2008, it shot up
and fluctuated widely. Baba and Packer focus on the shorter end of the market in their
study, but their findings yield similar flavour. Using CDS spreads and LIBOR-OIS
spreads as proxies, they find evidence that increase in counterparty risks of European
banks in general was the main driving force behind the departure from the parity condition
during the turmoil.5 The LIBOR-OIS spread is commonly used as a measure of market
perceptions of potential banking insolvency in the economy of the underlying interest rate,
i.e., a higher LIBOR-OIS spread implies higher banks’ default risk.6

2
The paper covers the study until 12 September 2008, i.e., before the Lehman default.
3
The 3-month contracts show similar results.
4
The data used in this paper are from Bloomberg.
5
An overnight index swap (OIS) is an interest rate swap in which the floating leg is linked to an index of
daily overnight rates. The two parties agree to exchange at maturity, on an agreed notional amount, the
difference between interest accrued at the agreed fixed rate and interest accrued at the floating index rate
over the life of the swap. The fixed rate is a proxy for expected future overnight interest rates. As
overnight lending generally bears lower credit and liquidity risks, the credit risk and liquidity risk
premiums contained in the overnight index swap rates should be small. Therefore, the spread of the
12-month LIBOR relative to 12-month OIS rate generally reflects the credit and liquidity risks of the
interbank market.
6
See an article written by Alan Greenspan in the last 2008 issue of The Economist, advocating the use of
the LIBOR-OIS spread as a measure of market perceptions of extra capital needs for banks.
 -4-

Chart 1. 12-month FX swap implied US dollar rate from euro

(% points) (% points)
2

6.5
1.5
EUR/USD swap-implied US

Implied US dollar rate over US dollar Libor

dollar rate over US dollar Libor
(rhs) 1
5.5

0.5
US dollar rate

4.5
0

3.5 -0.5

-1
2.5
-1.5
US dollar Libor (lhs) EUR/USD swap-implied US dollar rate (lhs)

1.5 -2
Jan-07 Mar-07 Jun-07 Aug-07 Nov-07 Jan-08 Apr-08 Jun-08 Sep-08 Nov-08
Date

III. EFFECTS OF COUNTERPARTY RISKS ON THE FOREIGN EXCHANGE MARKET

The recent financial turmoil has also had a significant impact on the foreign
exchange market. As compared to financial crises in the past, one of the distinct
characteristics of this crisis is how the resulting increase in counterparty risks paralyses the
money market. The impact of the crisis on the foreign exchange market and the channels
through which it was transmitted have so far gone almost unnoticed by economists and
policymakers. The significance of the Baba-Packer study lies in the uncovering of the
mechanism in which the rise in counterparty risks as a result of the turmoil feeds through
from the money to the swap market. This section points out that the financial turmoil has
led to a reappraisal of counterparty risks of different banking sectors, which has in turn led
to fundamental changes in international currency markets.

As European banks resorted to converting their euros into dollars to meet

their funding requirements, the euro began to appreciate rapidly. The euro had been on a
long-term upward trend vis-à-vis the dollar before the news of the near-collapse of Bears
Sterns in March 2008 (Chart 2). It had begun to stabilise since then. And when severe
financial difficulties of Freddie and Fannie surfaced in around August 2008, it fell sharply.
 -5-

Chart 2. Deviation of 12-month FX swap implied US dollar rate from dollar LIBOR
and EUR/USD exchange rate

16 Sept - Lehman default (% points)

0.6 1.8

1.6
Appreciation against US dollar

Implied US dollar rate over US dollar Libor

0.65 1.4

EUR/USD spot exchange rate (lhs) 1.2

EUR/USD exchange rate

0.7 1

EUR/USD swap-implied US 0.8

dollar rate over US dollar Libor
(rhs)
0.75 0.6

0.4
Depreciation against US dollar
0.8 0.2

0.85 -0.2
Jan-07 Mar-07 Jun-07 Aug-07 Nov-07 Jan-08 Apr-08 Jun-08 Sep-08 Nov-08
Date

Given that European banks are not alone in this global crisis, if this theory
is correct, the same should also be observed in economies where financial institutions also
suffered from a rise in counterparty risks, and their currencies should also experience
sell-off to a similar extent. In Chart 3, we plot the deviations of the various currencies’
swap-implied US dollar funding rates from the corresponding LIBOR. As can be seen,
some economies saw a significantly higher swap-implied funding rate over the US dollar
LIBOR after mid-September 2008 and, at the same time, a sharply lower currency (i.e., the
pound and the Australian dollar), while others enjoyed a swap-implied discount from the
US dollar LIBOR and, at the same time, a much stronger currency (i.e., the yen and the
Hong Kong dollar).7

7
The picture is less clear for the Singapore dollar.
 -6-

Chart 3. Deviations of 12-month FX swaps implied US dollar rate from dollar LIBOR and their respective exchange rates

GBP/USD GBP (%) EUR/USD EUR (%) AUD/USD AUD (%)

0.45 2 0.6 2 1 2
Deviation (rhs) Deviation (rhs)

1 1 1
1.2 Deviation (rhs)
0.55 0.7
0 0 0
1.4
GBP/USD spot EUR/USD spot AUD/USD spot
exchange rate (lhs) exchange rate (lhs) exchange rate (lhs)
-1 -1 -1
0.65 0.8
Depreciation against USD Depreciation against USD 1.6 Depreciation against USD
-2 -2 -2
Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08

HKD/USD HKD (%) JPY/USD JPY (%) SGD/USD SGD (%)

7.72 2 85 2 1.3 2
Appreciation against USD Appreciation against USD Appreciation against USD

Deviation (rhs) 1 95 Deviation (rhs) 1 1

1.4 Deviation (rhs)
7.77
0 105 0 0

1.5
-1 115 -1 -1
7.82 HKD/USD spot JPY/USD spot SGD/USD spot
exchange rate (lhs) exchange rate (lhs) exchange rate (lhs)
-2 125 -2 1.6 -2
Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08
 -7-

If Baba and Packer are right in pointing out that what recently happened in
the swap market reflects essentially a rise in counterparty risks spilling over from the
money market, the amount of premium or discount as reflected in the swap-implied US
dollar funding rates of different FX swaps can be taken a measure of relative risk of the
banking sectors of the economies concerned. The results of such measure should be
supported by the evidence in the LIBOR-OIS spread that reflects market perceptions of
potential banking insolvency.8 The 12-month LIBOR(or HIBOR)-OIS spreads of the
respective economies in Chart 4 clearly shows that the banking sectors in the US, the Euro
area, the UK and Australia had substantial higher default risk than those in Hong Kong,
Japanese and Singapore in the last quarter of 2008. The observations are consistent with
the premium or discount as reflected in the swap-implied US dollar funding rates of
different FX swaps.

Chart 4. 12-month LIBOR(HIBOR)-OIS spreads

(% points) (% points)
3.5 3.5

USD Libor - OIS British pound

3 AUD Libor - OIS 3
HKD Hibor - OIS Euro
SGD Sibor - OIS
2.5 2.5
GBP Libor - OIS Australian dollar
EUR Libor - OIS
2 JPY Libor - OIS 2
Libor - OIS spread

Libor - OIS spread

1.5 US dollar 1.5

1 1

0.5 0.5

0 0

-0.5 Japanese yen Hong Kong dollar -0.5

Singapore dollar

-1 -1
Jan-07 Mar-07 Jun-07 Aug-07 Nov-07 Jan-08 Apr-08 Jun-08 Sep-08 Nov-08
Date

To test statistically whether the changes of the differences between the

LIBOR-OIS spreads of the currencies concerned and the US dollar had effects on the
changes and volatility of their FX swap deviations, we employ the EGARCH(1,1) model
proposed by Nelson (1991) to test their data series from 9 August 2007 to 30 January
2009.9 Table 1 show that the series are not stationary in level but are stationary in the
first difference according to the augmented Dickey-Fuller test. The EGARCH(1,1) model
in the first difference we use can be written as

8
The CDS market only covers a few banks in Hong Kong and Singapore. Therefore, their CDS spreads
do not represent the risk of the banking sectors as a whole.
9
This follows Taylor and Williams (2008a, b) to choose 9 August 2007 to mark the inception of the turmoil,
when BNP Paribas frozen redemptions for three of its investment funds.
 -8-

Mean equation:
dFXdevt = a + b × d ( LIBOR − OIS ) tspread + ε t ε t ~ N 0, σ t2 ( ) (2)
where
St
FXdevt = (1 + rt ) − (1 + qt ) ≡ qt* − qt
Ft
( LIBOR − OIS ) tspread = ( LIBOR − OIS ) tFC − ( LIBOR − OIS )USD
t

Variance equation:
ε t −1 ε 
( ) ( )
ln σ t2 = α + β ln σ t2−1 + γ
σ t −1
+ η  t −1 − 2 / π 
 (3)
 σ t −1 
If the relative risk of the banking systems of the economies concerned is a determinant of
the premium or discount as reflected in the swap-implied US dollar funding rates of
different FX swaps, the coefficient b in Eq.(2) should be positive and statistically
significant.

Table 1. Augmented Dickey-Fuller test on the variables FXdevt and ( LIBOR − OIS )tspread
Sample period: 9 August 2007 to 30 January 2009
No. of observation: 349
FXdevt ( LIBOR − OIS )tspread

Currency Level Daily change Level Daily change

GBP -2.398 -4.983*** -2.490 -5.461***

EUR -2.378 -3.837*** -3.719*** -4.501***

AUD -2.115 -4.129*** -1.947 -6.442***

JPY -2.434 -5.751*** -2.071 -4.183***

HKD -1.752 -6.029*** -2.391 -5.447***

SGD -0.110 -5.335*** -2.361 -5.004***

1.) ADF statistics are from the Augmented Dickey-Fuller unit root test. The critical ADF
values at the 10%, 5% and 1% significance level are -2.57, -2.87 and -3.44 respectively.
2.) *, ** and *** indicate significant at 10%, 5% and 1% levels respectively.
3.) The lag length of the ADF test is selected according to the Schwarz Information Criteria
with maximum lags of 16.
 -9-

The results in Table 2 show the coefficients b for the six currencies are
positive and significant at the 1% level. This indicates that under the turmoil, FX swap
deviations in the euro, the pound and the Australian dollar tended to widen upward when
counterparty risk was heightened for the financial institution in these economies relative to
US counterparts. On the other hand, the deviations in the Hong Kong dollar, the yen and
the Singapore dollar tended to go downward as counterparty risk of the financial
institutions in these economies were perceived to low relative to US counterparts.

Therefore, in contrast to European and Australian banks (which need to

convert their currencies into US dollars to meet their funding requirements), Hong Kong,
Japanese and Singapore banks with swap-implied discounts from the US dollar LIBOR
(i.e., with less default risk) attract financial institutions (probably US banks) with US
dollars on hand to sell US dollars to these Asian banks at spot in the FX swaps.10 In this
connection, it becomes readily understandable why these Asian currencies appreciated
against the US dollar after the Lehman default.

IV. CONCLUDING REMARKS

This note analyses the impact of the global credit crisis on the FX swap
market and discusses its potential implications. A recent BIS study finds that the
turbulence in money markets has spilled over to FX swap markets amid a reappraisal of
counterparty risks during the recent financial turmoil. The spillover occurred, as
European banks needed to secure US dollar funding to support their US conduits while US
banks were cautious in lending to them. This forced the European banks to resort to
converting their euros into dollars in the swap market, giving rise to a risk premium in the
dollar funding rates in the swap. In the note, we extend the BIS analysis to examine the
situations of five other currencies. We find that (i) the risk premiums have indeed gone
in tandem with the spreads of money market rates over their corresponding overnight
index swaps across the economies, a popular measure of potential banking insolvency; and
(ii) the risk premiums bear a negative relationship with the strength of the spot rates of the
respective currencies, which is consistent with the increased pressure in the swap markets.
The implication of the analysis is that the directions of fund flows among different
economies may reflect the relative safety and soundness of their banking systems during
the credit crisis period.

10
The counterparty risk at the forward legs of the swaps is also relative low for these Asian banks.
 - 10 -

Table 2. Estimation results of EGARCH(1,1) model

Sample period: 10 August 2007 to 30 January 2009 (No. of observation = 348 after adjustment)

Mean equation Variance equation Ljung-Box test up to lag 24

Currency Standardized Squared

standardized
a b α β γ η residuals Adj R-squared
(P-value) residuals (P-value)

0.0006 0.884** -0.772** 0.947** 0.147 0.585** 13.875 17.912

GBP 0.746
(0.002) (0.023) (0.262) (0.029) (0.094) (0.149) (0.949) (0.807)

0.002 0.856** -0.387 0.988** 0.139 0.454* 17.528 18.759

EUR 0.526
(0.002) (0.025) (0.238) (0.021) (0.106) (0.212) (0.825) (0.765)

0.003 0.717** -0.367** 0.971** 0.127 0.279** 35.233 16.628

AUD 0.467
(0.003) (0.037) (0.096) (0.015) (0.069) (0.074) (0.065) (0.864)

0.002 0.876** -0.755* 0.940** 0.004 0.551* 30.836 20.637

JPY 0.440
(0.002) (0.022) (0.325) (0.037) (0.097) (0.226) (0.159) (0.660)

0.003 0.510** -0.416 0.967** 0.080 0.301** 38.250 32.694

HKD 0.422
(0.003) (0.037) (0.265) (0.038) (0.072) (0.086) (0.033) (0.111)

-0.0002 0.304** -0.503 0.946** -0.026 0.301** 43.209 23.188

SGD 0.158
(0.004) (0.029) (0.286) (0.047) (0.074) (0.092) (0.009) (0.509)

1.) Numbers in parentheses are Bollerslev-Wooldrige robust standard errors. * and ** indicate significant at 5% and 1% levels respectively.
2.) The Ljung-Box test (Q-statistics) identifies whether the autocorrelations among data are jointly zero up to a specified lag. Accepting the null hypothesis of the test
means the data is not serial correlated. The standardised residual is the residual divided by the estimated volatility.
3.) If the model fits well, the standardized residual will be serial uncorrelated and homoskedastic. If the mean equation is correctly specified, the Q-statistic of the
standardized residual should not be significant; if the variance equation is correctly specified, the Q-statistics of the squared standardized residuals should not be
significant.
 - 11 -

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Journal of Political Economy 96: 358-370.

Frenkel J. A., Levich R. M. 1977. Transaction Costs and Interest Arbitrage: Tranquil
versus Turbulent Periods. Journal of Political Economy 85: 1209-1226.

Nelson B. 1991. Conditional Heteroskedasticity in Asset Returns: A New Approach.

Econometrica 59, 347-370.

Taylor J. B., Williams, J. C. 2008a. A Black Swan in the Money Market. NBER Working
Paper No. 13493.

Taylor J. B., Williams, J. C. 2008b. Further Results on a Black Swan in the Money Market.
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376-391.