Price Discovery from Cross-Currency and FX Swaps: A Structural Analysis

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.