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Price Discovery from Cross-Currency and FX Swaps:

A Structural Analysis

July 2007
Yasuaki Amatatsu*1
Naohiko Baba*2

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This paper investigates the relative role of price discovery between two long-term swap contracts that exchange between the U.S. dollar and the Japanese yen: cross-currency basis swap and FX (foreign exchange) swap. First, we show that these two swaps should be in a no-arbitrage relationship by allowing for differential risk premiums. Second, we empirically investigate the relative role of price discovery using the structural-form approach based on the state space models. Main finding are as follows. (i) The efficient prices extracted as a common factor of the two swaps show a very similar movement, regardless of model specifications. (ii) The currency swap market plays a much more dominant role in price discovery than the FX swap market. (iii) The FX swap prices tend to under-react to the efficient price changes, while the cross-currency swap prices almost exactly react to them.

Key Words:
Currency Swap; FX Swap; Price Discovery, State Space Model, Efficient Pricep

JEL Classification:
G12, G14, G15

The authors are grateful to Bruce Lehmann, Yoichi Matsubayashi, and seminar participants at the Bank for International Settlement and the Bank of Japan, particularly to Claudio Borio, Andrew Filardo, Keiji Kono, Teppei Nagano, and Frank Packer for useful comments and suggestions. Any remaining errors are solely our responsibility. We also benefited from interviews with swap traders in London and Tokyo. The views expressed in this paper are solely of the authors and do not necessarily reflect those of the Bank of Japan.

  • *1 Financial Markets Department, Bank of Japan
  • *2 Financial Markets Department, Bank of Japan


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