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FRM Part II · FRM Exam Part II

Covered Interest Parity Lost: Understanding the Cross-Currency Basis

Covered interest parity says a hedged foreign investment should earn the same return as a domestic one. The cross-currency basis is the gap when it does not. Since 2008 the basis has often been negative for USD borrowing, reflecting USD funding demand and limits to arbitrage. Solve questions by comparing hedged funding costs.

What this chapter covers

This chapter explains why a rule once treated as a near-law of finance stopped holding. Covered interest rate parity (CIP) links spot rates, forward rates and interest rates in two currencies. If it holds, you cannot earn a riskless profit by borrowing in one currency, converting, investing in another and hedging the exchange rate with a forward.

You then see how the market actually prices this link. FX swaps and cross-currency basis swaps are the tools used to borrow one currency against another. The cross-currency basis is the spread added to the foreign-currency interest rate so that CIP holds in practice. A negative basis against the USD means borrowing USD through the swap market costs more than the USD interest rate alone suggests.

The chapter connects directly to the Liquidity and Treasury Risk topic and to market risk. Banks outside the US fund in USD through swaps, so a wide basis is a funding-stress signal. Expect applied questions that ask you to read a basis, explain its driver and state the treasury consequence.

The chapter is compact, but it ties together FX, funding and arbitrage, so it rewards clear thinking more than memorisation. Questions are usually conceptual or light on numbers: sign of the basis, who pays it, why arbitrage does not close it, and what it means for a bank's USD funding. Once you understand the logic, you can answer most of them by reasoning, and the same ideas support other liquidity and funding questions across the paper.

Covered Interest Parity Lost: Understanding the Cross-Currency Basis: topics in the order to study them

  1. 1Covered Interest Rate Parity (CIP) BasicsEverything else is a deviation from this benchmark, so you need the no-arbitrage logic and formula first.
  2. 2FX Swaps and Cross-Currency Basis SwapsYou need to know the instruments and cash flows before you can read what the basis measures.
  3. 3Covered Interest Parity Deviations Since 2008With the benchmark and instruments clear, you can study when, where and how large the deviations became.
  4. 4Drivers of the Basis: Funding Demand and Limits to ArbitrageThis explains why the deviations persist, using balance-sheet and regulatory constraints on arbitrageurs.
  5. 5Implications for Liquidity Risk and Treasury ManagementThis is the application layer, where exam questions link the basis to funding costs and treasury decisions.

How to prepare Covered Interest Parity Lost: Understanding the Cross-Currency Basis

Build the chapter from a single logic chain: parity, instrument, deviation, cause, consequence. Spend time on reasoning, not just definitions.

  1. Write the CIP condition in words first: a hedged foreign investment should match the domestic return. Then write it in forward-rate form and check that a higher-rate currency trades at a forward discount.
  2. Draw the cash flows of an FX swap on paper: exchange at spot now, reverse at the forward rate later. Do the same for a cross-currency basis swap, noting the basis spread on the non-USD leg.
  3. Practise one numeric parity check: compute the implied forward from spot and both interest rates, compare with the market forward, and decide which direction an arbitrage would run.
  4. Learn the sign convention. A negative basis against the USD means a premium to obtain USD through the swap. Say it aloud until you never flip it.
  5. List the drivers in two groups: demand for USD funding, and limits to arbitrage such as balance-sheet costs and regulation. Be ready to match each to a scenario.
  6. Finish by writing a short treasury note: what a widening basis does to a non-US bank's USD funding cost and what actions it might take. Then do timed practice questions.

Common mistakes in Covered Interest Parity Lost: Understanding the Cross-Currency Basis

  • Flipping the sign of the basis or saying who pays it.

    Fix: Remember that a negative basis against USD means USD is expensive to obtain via swaps. Restate each question in those terms.

  • Treating CIP as a prediction of future spot rates.

    Fix: CIP uses the forward rate and is a no-arbitrage link with no exchange rate risk. Uncovered parity relies on expected spot and is a different idea.

  • Saying arbitrageurs should simply eliminate the deviation.

    Fix: Cite limits to arbitrage: balance-sheet and regulatory costs and capital constraints make the trade unattractive even when a gap exists.

  • Mixing up an FX swap with a currency swap with exchange of interest.

    Fix: An FX swap is a spot exchange with a forward reversal. A cross-currency basis swap exchanges interest payments over its life.

  • Using interest rates for the wrong horizon in a parity calculation.

    Fix: Match the rate term to the forward maturity, and apply the correct day-count or fraction of a year before comparing.

  • Ignoring the treasury link and answering only with FX theory.

    Fix: For applied questions, connect the basis to USD funding cost, rollover risk and liquidity buffers.

Last-day revision: Covered Interest Parity Lost: Understanding the Cross-Currency Basis

  • CIP: a covered (hedged) foreign investment should earn the same return as the domestic one.
  • Forward-rate form: F = S × (1 + i domestic) ÷ (1 + i foreign), with rates quoted for the same horizon and the exchange rate as domestic per foreign.
  • The higher-interest-rate currency trades at a forward discount if CIP holds.
  • An FX swap exchanges currencies at spot and reverses at a forward rate; it is a collateralised-style funding tool.
  • A cross-currency basis swap exchanges floating-rate payments in two currencies, with the basis spread added to the non-USD leg.
  • A negative basis against USD means the implied cost of borrowing USD through swaps exceeds the direct USD rate.
  • CIP deviations became large and persistent after the 2008 global financial crisis.
  • A key driver is strong demand for USD funding from non-US banks and investors.
  • Limits to arbitrage include balance-sheet costs and regulatory constraints, so arbitrageurs do not fully close the gap.
  • A wider basis signals USD funding stress and raises hedged funding costs.
  • Treasury responses include diversifying funding sources, managing USD liquidity buffers and rollover risk.

Covered Interest Parity Lost: Understanding the Cross-Currency Basis practice questions

Covered Interest Parity Lost: Understanding the Cross-Currency Basis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Covered Interest Parity Lost: Understanding the Cross-Currency Basis: frequently asked questions

What is the cross-currency basis in simple terms?

It is the extra spread needed so that borrowing one currency through the swap market matches the cost implied by covered interest parity. A negative basis against the USD means getting USD through swaps costs more than the plain USD interest rate.

Why did covered interest parity stop holding after 2008?

Demand for USD funding rose and arbitrage became costly for banks because of balance-sheet and regulatory constraints. Arbitrageurs could not fully close the gap, so the deviations persisted.

Do I need to do calculations for this chapter in FRM Part II?

Expect mostly conceptual or light numerical questions. Know how to compute an implied forward from spot and interest rates and judge the direction of a parity deviation.

How does the basis affect a bank's treasury?

A wider negative basis raises the cost of hedged USD funding and signals funding stress. Treasury teams respond by managing USD liquidity buffers, diversifying funding sources and watching rollover risk.