I’m confused about terminology, specifically when a cross-currency swap is considered to have “positive” or “negative” basis. In particular, these 2 sections in the curriculum appear (to me) to contradict each other:
Reading 9 Page 98 - The first paragraph refers to a US investor and says when the basis is “negative”… when USD demand is strong relative to Yen, thus borrowing in USD is higher relative to Yen, making lending USD particularly attractive
Practice Problem #5 on page 124 refers also to a US investor…again USD demand stronger relative to Euros, but now the curriculum calls this “positive basis” for ‘lending’ USD.
@oldman , think of a xccy basis swap as a combination of two separate legs:
one leg where you are borrowing a given currency (e.g. you receive USD notional upfront, receive USD interest payments throughout, and receive USD notional at maturity)
one leg where you are lending the other currency (e.g. you pay a JPY notional upfront, receive JPY interest payments, and receive JPY notional at maturity)
In the interbank market, the basis is quoted as the interest rate spread paid on the non-USD leg (in my example, the basis would be a spread paid on the floating JPY leg, against a floating USD leg with no spread). When there is a lot of demand for USD funding by Japanese banks, the xccy basis becomes more negative (Japanese banks are willing to receive less and less on their JPY leg in order to borrow USD).
It looks to me like it is Practice Problem #5 that is misleading (I don’t have access to the study material you are referring to, so I’m going with @Mr.E’s interpretation). No market participant would ever say that the strong demand for borrowing USD would result in a “positive basis” for ‘lending’ USD. Again, the basis is always quoted on the non-USD leg, so a market participant might say that “European banks are willing to pay a big premium to secure USD funding (resulting in a very negative EUR/USD xccy basis)”.
Unfortunately it looks like whoever is writing the xccy basis material is not using standard market conventions, and you have to figure out from the wording whether they are referring to a spread on the USD leg (Reading 9 p 98) or whether they are referring to a spread on the non-USD leg (Practice Problem #5 on page 124).
~99.9% of interbank xccy basis trades against USD.
If someone asks for a quote on a cross, he would explicitly ask for a specific convention (“I want to receive GBP floating and pay AUD + spread. What is your offer?”).
The cross currency basis is a number of basis points (positive or negative), that is added to the non-USD leg of the xccy swap. The EUR/USD xccy basis has been mostly negative in recent years (although it has turned positive at times).
One way to interpret this is that European banks had access to lots of cheap EUR funding thanks to ECB QE. However they had more difficulties raising USD (e.g. because of reforms in US money market funds, etc.). In order to secure USD funding at LIBOR flat, they were willing to lend EUR at EURIBOR plus negative spread (i.e. the basis was reducing the interest amounts they were receiving on the EUR leg).
