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FRM Exam Part II · The US Dollar Shortage in Global Banking and the International Policy Response

Currency Mismatch and FX Swap Market Funding for FRM Part II

Updated 11 October 2026 · Fact-checked

Banks with dollar assets but few dollar deposits borrow dollars by swapping local currency in an FX swap: spot exchange now, reverse at a forward rate later. The swap is off-balance-sheet, so the FX mismatch is hidden. The cross-currency basis measures the extra cost of borrowing dollars this way versus covered interest parity.

Understand Currency Mismatch and FX Swap Market Funding

Many non-US banks hold large dollar assets: loans, bonds and trade finance. But they lack a matching base of dollar deposits. They need to fund the gap. They can borrow dollars directly in wholesale markets, or they can borrow euros, yen or rupees and convert them into dollars.

The FX swap is the main tool for the second route. The bank sells local currency and buys USD at spot. At the same time it agrees to reverse the trade at a forward rate on a set date. Economically it is a collateralised dollar loan. The forward rate carries the interest rate difference between the two currencies. A cross-currency basis swap does the same job for longer terms. The two sides swap principal at the start and end, and exchange floating interest payments in each currency, with the basis spread added to the non-dollar leg.

Under covered interest parity (CIP), borrowing dollars directly and borrowing local currency plus an FX swap should cost the same. Since 2008 they often do not. The cross-currency basis is the gap. A negative basis (for example EUR/USD at -30 bp) means you pay more than the dollar rate to get dollars through the swap. A wider negative basis signals strong dollar demand and limited arbitrage capacity.

The risk is hidden. A swap is an off-balance-sheet derivative. The bank's balance sheet shows dollar assets funded by local currency, yet the swap creates a forward obligation to hand dollars back. That obligation is a dollar liability not shown on the balance sheet. Currency mismatch looks smaller than it is. The real exposure is rollover risk: short-term swaps must be renewed. If the basis spikes or counterparties pull back, the bank cannot refinance and may need central bank swap lines.

So the exam logic is: dollar asset, local currency funding, FX swap bridges it, the basis is the price, and rollover plus collateral calls are the risk. The swap hedges FX price risk but leaves funding liquidity risk.

Key formulas to remember

Covered interest parity (CIP)
F ÷ S = (1 + r_local) ÷ (1 + r_USD) (F, S in local currency per USD; same tenor)
Holds with no frictions. Forward premium or discount reflects the interest rate difference.
Cross-currency basis (common quote)
Basis x = r_USD − r_synthetic USD, quoted as a spread added to the non-USD rate in the swap
Negative x means synthetic dollars cost more than direct dollar borrowing. Conventions vary, so read the question.
Implied (synthetic) USD rate from an FX swap
With S and F in local per USD: 1 + r_synthetic USD = (1 + r_local) × (S ÷ F). With S and F in USD per local currency (for example USD per EUR): 1 + r_synthetic USD = (1 + r_local) × (F ÷ S)
Use for tenor of one period. For tenors over a year, annualise. Check the quote direction first, because the ratio flips with it.
Deviation from CIP
Deviation = r_USD − r_synthetic USD observed
This has the same sign as the basis x. A negative deviation means an extra cost to obtain dollars through the swap.

How to solve Currency Mismatch and FX Swap Market Funding questions

Use this order for any question on FX swap funding, the basis or hidden currency mismatch.

  1. 1Identify the bank's assets and liabilities by currency. Find the funding gap in USD.
  2. 2State how the gap is bridged: direct USD borrowing, or local currency plus FX swap or basis swap.
  3. 3Describe the swap legs: spot exchange now, reverse at the forward rate later. Check whether it is an FX swap (short term, principal only) or a cross-currency swap (longer, with interest legs).
  4. 4If numbers are given, write the quote direction first. With rates in local currency per USD, synthetic USD rate = (1 + r_local) × S ÷ F − 1. With rates in USD per local currency (for example USD per EUR), synthetic USD rate = (1 + r_local) × F ÷ S − 1.
  5. 5Compare with the direct USD rate. The basis or CIP deviation is direct USD rate minus synthetic USD rate. Note its sign and meaning: negative means synthetic dollars cost more.
  6. 6Check the balance sheet. The forward leg is an off-balance-sheet USD obligation, so reported mismatch understates exposure.
  7. 7Name the risk: rollover, margin or collateral calls, basis widening, or reliance on central bank swap lines.
  8. 8Pick the answer that matches the correct sign, tenor and risk.

Quickest way: Three-check shortcut

When to use it: For conceptual MCQs when you have under a minute.

  1. Check direction: who needs USD and who lends USD against local currency?
  2. Check sign: a negative basis means dollars are expensive through the swap.
  3. Check what is hidden: the forward leg is an off-balance-sheet USD liability, and the risk is rollover, not FX price risk.
  4. Eliminate options that say the swap removes liquidity risk or that the basis is positive when USD demand is high.

Common mistakes in Currency Mismatch and FX Swap Market Funding

  • Saying an FX swap removes all risk from a currency mismatch.

    The swap fixes the forward rate, so the FX price risk seems gone.

    Fix: It fixes the exchange rate but not rollover risk. If the swap cannot be renewed, the bank faces a funding shortfall.

  • Treating the FX swap as a derivative with no funding role.

    It is booked off-balance-sheet, so students think of it as only a hedge.

    Fix: Think of it as a collateralised loan of one currency against another.

  • Getting the sign of the basis wrong.

    Quote conventions differ and the basis is added to the non-USD leg.

    Fix: Ask whether synthetic dollars cost more than direct dollars. If yes, the basis is negative in the standard convention.

  • Mixing up FX swaps and cross-currency basis swaps.

    Both exchange currencies and both embed the basis.

    Fix: FX swaps are usually short term with no interim interest exchange. Basis swaps are longer, exchange principal at start and end, and swap floating interest each period.

  • Using the wrong exchange rate quote in the CIP formula.

    EUR/USD is quoted as USD per EUR, the opposite of local per USD.

    Fix: Write the quote direction first. Convert so both S and F are local currency per USD, or invert the formula.

  • Assuming CIP deviations are free arbitrage.

    Textbook CIP implies arbitrage would close any gap.

    Fix: Arbitrage uses balance sheet. Leverage ratios and capital limits restrict it, so gaps can persist.

Worked examples

Example 1

A euro-area bank needs USD for one year. The 1-year EUR rate is 3.00%. Spot EUR/USD is 1.1000 USD per EUR, and the 1-year forward is 1.1250 USD per EUR. The direct 1-year USD borrowing rate is 5.00%. Find the synthetic USD rate and the basis versus direct USD borrowing.

Show the solution
  1. Borrow €1 at 3.00%. Repay €1.03 in a year.
  2. Swap into USD at spot: €1 becomes $1.1000.
  3. Buy euros forward to repay: the bank needs €1.03, costing 1.03 × 1.1250 = $1.15875.
  4. Synthetic USD rate = 1.15875 ÷ 1.1000 − 1 = 5.341%. This equals (1 + r_EUR) × F ÷ S − 1 with quotes in USD per EUR.
  5. Check with quotes in EUR per USD: S = 0.9091 and F = 0.8889. Then 1.03 × 0.9091 ÷ 0.8889 − 1 is also about 5.34%.
  6. Basis x = direct − synthetic = 5.00% − 5.341% = −0.341%, about −34.1 bp.
  7. Synthetic dollars cost more than direct dollars, so the basis is negative.

Answer: The synthetic USD rate is about 5.34%, which is about 34.1 bp above the direct 5.00%. The basis is about −34 bp, so the swap route is more expensive.

Example 2

A Japanese bank holds USD 10 billion of loans funded with yen, using 3-month rolling FX swaps. Its balance sheet shows no USD liability. Explain the hidden exposure and the main risk. Which is correct: (A) none, since swaps hedge FX fully; (B) a USD obligation off balance sheet that must be rolled; (C) only interest rate risk; (D) only credit risk on loans?

Show the solution
  1. The bank sold yen for USD spot and agreed to buy yen back with USD at the forward date.
  2. The forward leg is a commitment to deliver USD in three months. It is an off-balance-sheet USD liability of about USD 10 billion.
  3. The loans last longer than three months. The bank must renew the swap each quarter.
  4. If the basis widens or counterparties pull back, renewal costs more or fails. That is rollover and funding liquidity risk.
  5. Option A ignores rollover. Options C and D omit the dominant risk.

Answer: (B): an off-balance-sheet USD obligation that must be rolled, exposing the bank to rollover and basis risk.

Exam tips

  • Questions often hide the mismatch: look for derivative footnotes or off-balance-sheet items beside a balance sheet with no USD liability.
  • Read exchange rate quotes carefully. USD per EUR versus EUR per USD changes the answer.
  • Link the basis to its drivers: USD funding demand, limits on arbitrage, and central bank swap lines as a backstop.
  • In numerical items, write the synthetic USD rate first, then compare with direct USD borrowing.
  • Distinguish FX price risk (hedged by the swap) from funding liquidity risk (not hedged).

Practice questions from The US Dollar Shortage in Global Banking and the International Policy Response

Currency Mismatch and FX Swap Market Funding in other exams

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

Currency Mismatch and FX Swap Market Funding: frequently asked questions

What is the difference between an FX swap and a cross-currency swap?

An FX swap exchanges currencies at spot and reverses at a forward rate, usually for short terms, with no interim interest payments. A cross-currency basis swap runs longer, swaps principal at start and end, and exchanges floating interest in each currency with the basis added to one leg.

How do FX swaps fund dollar assets?

The bank gives local currency and receives dollars at spot, then returns the dollars and gets local currency back at the forward date. This works like a collateralised dollar loan. The bank uses the dollars to hold dollar assets and rolls the swap as it matures.

What does a negative cross-currency basis mean?

It means getting dollars through an FX swap or basis swap costs more than borrowing dollars directly. It shows strong demand for dollars and limited arbitrage capacity, which is a breach of covered interest parity.

Why do FX swaps hide currency mismatch?

They are off-balance-sheet derivatives, so the forward obligation to deliver dollars does not appear as a liability. Reported currency mismatch looks smaller than the true dollar funding need.