What is an FX swap, and what is the cross-currency basis?

Currency swaps are where the plumbing of the global financial system is most visible. They are also where a quiet number — the cross-currency basis — tells you how stressed that plumbing is.

The FX swap — two trades stapled together

An FX swap is a spot exchange of two currencies today, combined with an agreement to reverse it at a fixed rate on a future date. You hand over euros and receive dollars now; on the agreed date you hand back the dollars and take back your euros at a rate set today.

It is not a directional currency bet. It is collateralised borrowing in one currency against another. A European bank that needs dollars for three months but funds itself in euros doesn't need to buy dollars and hope — it swaps.

Where the forward rate comes from

The rate on the far leg comes straight out of the two interest rates, because interest is what the swap is really exchanging:

Forward ≈ Spot × (1 + rate of quoted currency) ÷ (1 + rate of base currency)

Say EUR/USD spot is 1.1000, the one-year dollar rate is 5%, and the one-year euro rate is 3%:

1.1000 × 1.05 ÷ 1.03 = 1.1214

So the one-year forward sits about 214 pips above spot — the two-point interest gap, charged in currency rather than in interest. Set the far leg anywhere else and someone borrows in one currency, swaps, lends in the other, and books a risk-free profit. That arbitrage is what pins the number, and the principle has a name: covered interest parity.

The basis — when parity doesn't hold

In textbooks, covered interest parity holds. In reality, it doesn't quite. The gap between the interest rate implied by the FX swap market and the rate available in the cash market is the cross-currency basis, quoted in basis points on the non-dollar leg.

A negative basis means the market is charging a premium to supply dollars through the swap market — dollars are scarcer there than the interest-rate arithmetic alone would suggest. That premium exists because arbitrage takes balance sheet, capital and credit lines, and those are finite.

The basis behaves like a stress gauge. It sits near zero in calm periods and widens sharply — to the order of a hundred basis points or more for major pairs — in episodes of dollar funding strain, including the 2008 crisis and March 2020. Central banks operate swap lines with each other specifically to relieve that pressure, which is why "swap lines expanded" is a genuinely important headline rather than jargon.

Cross-currency swap vs FX swap

The names are close, the contracts differ:

• FX swap — short-dated, two exchanges, no interest payments in between.
• Cross-currency swap — longer-dated, principal exchanged at both ends, and interest paid in both currencies throughout the life. This is what a company issuing a bond in a foreign currency uses to turn those foreign-currency coupons back into its home currency.

Try it now

1. Take today's spot for a major pair, EUR/USD, and an overnight rate for each of the two currencies: SOFR for the dollar and €STR for the euro. All three are below, in that order.

2. Compute the one-year forward with the formula above. Which currency trades at a forward premium — and confirm for yourself that it is the lower-rate one.
3. Say what you computed in one sentence, using neither "forecast" nor "expect." If it still reads as a prediction, you have not yet believed the arithmetic: the far leg is the price of borrowing one currency against the other, and a price is not an opinion.