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FRM Exam Part II · Covered Interest Parity Lost: Understanding the Cross-Currency Basis

Covered Interest Parity Deviations Since 2008

Updated 11 October 2026 · Fact-checked

Covered interest parity (CIP) says a hedged foreign-currency investment should earn the same as a domestic one. Since 2008 it has failed: the cross-currency basis for dollars against EUR and JPY has stayed negative. Borrowing dollars through FX swaps costs more than cash-market rates imply. To solve questions, compute the implied dollar rate and compare it with the actual rate.

Understand Covered Interest Parity Deviations Since 2008

Covered interest parity is a no-arbitrage rule. You can lend in one currency. Or you can swap into another currency, lend there, and lock in the way back with a forward contract. Both routes should give the same return. If they do not, a trader could borrow in the cheap route, lend in the dear route, and earn a risk-free profit.

Before 2008, CIP held closely in major currencies. After the global financial crisis, it stopped holding. The gap is called the CIP deviation or cross-currency basis. It is usually quoted in basis points and added to the non-dollar interest rate leg of a cross-currency basis swap, for example EUR 3-month rate + basis against USD 3-month rate.

A negative basis means the non-dollar side pays less than its plain interest rate. Put simply, someone who lends euros or yen and receives dollars through the swap gets fewer euros than the cash rate implies. That is the price of dollars. Dollar funding obtained through the FX swap market costs more than dollar funding obtained directly in the cash market.

Why does it persist? Arbitrage needs balance sheet. A bank that borrows dollars cheaply and lends them through the swap market must hold assets and liabilities against leverage ratios and risk-weighted capital rules. Post-crisis rules, such as the Basel III leverage ratio, made these trades costly. Credit risk limits on counterparties and quarter-end window dressing also add to the cost. These are called limits to arbitrage.

The other side is demand. Non-US banks, insurers and pension funds hold dollar assets but earn local currency. They hedge the currency risk through FX swaps and cross-currency swaps, which creates a steady demand for dollars forward. When that demand is large and supply of arbitrage capital is limited, the basis stays negative. It widens in stress, such as the 2011 euro area crisis and March 2020, and central bank dollar swap lines help narrow it.

Key formulas to remember

Covered interest parity (no-arbitrage)
F ÷ S = (1 + i_d) ÷ (1 + i_f)
S and F are spot and forward in domestic currency per unit of foreign currency. i_d is the domestic rate, i_f the foreign rate, over the same period. The forward premium offsets the interest differential.
Implied USD rate from FX swap (quote: USD per EUR)
(1 + i_USD,implied) = (1 + i_EUR) × F ÷ S
Use S and F as USD per EUR. Gives the dollar rate you pay by borrowing euros and swapping into dollars. Annualise for periods under a year.
CIP deviation (basis)
x = i_USD,cash − i_USD,implied
Sign conventions differ. In the usual quoting, x is negative when swap-implied dollar borrowing costs more than cash USD rates. Always check which rate is compared with which.
Annualised forward premium or discount
(F − S) ÷ S × (360 ÷ days)
Positive means the foreign currency is at a forward premium. Use the day-count the question gives.

How to solve Covered Interest Parity Deviations Since 2008 questions

Use this method for numeric and conceptual questions on CIP deviations and the cross-currency basis.

  1. 1Identify the currency pair and the quote convention. Decide which currency is the base, so you know whether S and F are USD per EUR or the reverse.
  2. 2Write the two routes: direct dollar cash borrowing or lending, and synthetic dollars via the foreign currency plus an FX swap.
  3. 3Compute the synthetic (implied) rate using the formula, adjusting for the period length and day count.
  4. 4Compare it with the actual cash rate. The difference is the basis. State its sign and size in basis points.
  5. 5Interpret the sign. A negative basis means a dollar premium: synthetic dollar funding is more expensive than cash dollar funding.
  6. 6Name the cause: hedging demand for dollars and limits to arbitrage such as leverage ratio and balance sheet costs. Link to stress and central bank swap lines if the question asks.
  7. 7Check the direction of any trade: who gains from the negative basis, a dollar lender or a dollar borrower?

Quickest way: Dollar-premium shortcut

When to use it: Use when the question gives rates and a forward points figure, or asks only for the sign or direction of the basis.

  1. Approximate the implied dollar rate as foreign rate + forward premium on the foreign currency, annualised.
  2. Subtract it from the actual dollar rate. If synthetic dollars cost more, the basis is negative.
  3. Eliminate options that say CIP holds exactly or that a negative basis means dollars are cheap.
  4. Check the four options have different magnitudes before computing exactly.

Common mistakes in Covered Interest Parity Deviations Since 2008

  • Saying a negative basis means dollars are cheap to borrow.

    The word negative feels like a lower cost.

    Fix: Remember that the basis is added to the non-dollar leg. A negative basis lowers what a euro or yen lender receives, so dollars obtained via swaps cost more.

  • Using S and F in the wrong direction.

    Quote conventions differ across currency pairs.

    Fix: Write out the quote, for example USD per EUR, before inserting numbers. Check that the answer is sensible.

  • Treating the deviation as a riskless arbitrage profit anyone could take.

    Textbook CIP is an arbitrage condition.

    Fix: State that arbitrage is limited by balance sheet costs, leverage ratio, capital rules and counterparty limits. The profit is not free of cost.

  • Ignoring the period length and day count.

    Candidates apply annual rates to a three-month swap.

    Fix: Scale each rate by days ÷ 360 (or the stated convention) and annualise at the end.

  • Claiming the basis disappeared after the crisis ended.

    Candidates link it only to the 2007–2009 funding shock.

    Fix: Recall that it has persisted for major currencies since 2008 and widens in stress periods, especially around quarter-ends and market shocks.

Worked examples

Example 1

Spot EUR/USD is 1.1000 (USD per EUR). The 3-month forward is 1.1066. The 3-month EUR rate is 3.00% per year and the 3-month USD rate is 5.00% per year, both simple, using 360 days and a 90-day period. Find the swap-implied USD rate (annualised) and say whether the basis is positive or negative.

Show the solution
  1. Euro growth over 90 days: 1 + 0.03 × 90 ÷ 360 = 1.0075.
  2. F ÷ S = 1.1066 ÷ 1.1000 = 1.006.
  3. Implied USD growth = 1.0075 × 1.006 = 1.013545.
  4. Implied USD period rate = 1.3545%. Annualised: 1.3545% × 360 ÷ 90 = 5.418%.
  5. Cash USD rate = 5.00%. Implied is 5.418%, higher than cash.
  6. Basis = 5.00% − 5.418% = −0.418%, about −42 bp.

Answer: Implied USD rate ≈ 5.42%. The basis is negative, about −42 bp: synthetic dollars cost more than cash dollars.

Example 2

A bank sees a persistent negative EUR/USD basis. Which statement is the best explanation of why a negative basis can persist without being arbitraged away? A) Dollar interest rates are always below euro rates. B) Banks face balance sheet and leverage costs that limit arbitrage while hedging demand for dollars is high. C) Forward contracts cannot be priced from interest rates. D) Central banks forbid cross-currency swaps.

Show the solution
  1. Option A is wrong: CIP concerns the hedged comparison, not a level rule about which rate is higher.
  2. Option C is wrong: forwards are priced from interest differentials, which is the CIP idea itself.
  3. Option D is wrong: swaps are widely used, and central banks run dollar swap lines in stress.
  4. Option B matches the accepted explanation: demand to swap into dollars plus costly balance sheet space for arbitrageurs.

Answer: B

Exam tips

  • Know the sign convention: negative basis equals a premium for obtaining dollars through swaps.
  • Expect both a calculation (implied rate versus cash) and an interpretation question. Do the arithmetic, then state what the sign means.
  • Link causes to Basel-era constraints: leverage ratio, risk-weighted capital and counterparty limits as limits to arbitrage.
  • Remember that the basis widens in stress and central bank swap lines are the policy response.
  • Watch the quote direction and day count before computing.

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

Covered Interest Parity Deviations Since 2008 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 Deviations Since 2008: frequently asked questions

Why did covered interest parity break down after 2008?

Banks lost the spare balance sheet and credit capacity needed to arbitrage, and new rules made the trades costly. At the same time, demand for dollars through FX swaps stayed high. The result was a persistent gap between swap-implied and cash dollar rates.

What does a negative cross-currency basis mean?

It means borrowing dollars through an FX or cross-currency swap costs more than the plain interest rates suggest. It is often called a dollar premium. The size is quoted in basis points.

Does the CIP deviation affect all currencies the same way?

No. It has been most notable for the euro and yen against the dollar. Its size varies over time and widens in stress periods.

Is the CIP deviation a free arbitrage profit?

Not in practice. Arbitrage needs balance sheet space, and leverage ratios, capital rules and counterparty limits make it costly. That is why the deviation persists.