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

A bank funds long-dated USD assets with rolling three-month FX swaps. During a period of market stress, the cross-currency basis widens sharply. Which risk is most directly highlighted by this funding structure?

The structure primarily creates rollover or refinancing risk. Short-term FX swaps must be renewed repeatedly while the dollar assets are long-dated, so a widening basis raises costs and may reduce availability at each roll, leaving the bank exposed to a funding squeeze in stress.

  1. ARollover (refinancing) risk, because swap costs and availability can deteriorate at each renewal while the assets remain illiquidCorrect
  2. BBasis risk on the asset side only, because asset yields are fixed in dollars
  3. CCredit risk on the swaps being eliminated by the short tenor
  4. DInterest rate risk being fully hedged by the rolling swaps

Explanation

Short-dated swaps financing long-dated assets create a maturity mismatch. Each roll exposes the bank to a wider basis and possibly reduced counterparty willingness. The other options wrongly claim risks are eliminated or hedged.

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