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

A bank has a 3-month USD LIBOR-equivalent rate of 5.00% and a 3-month EUR rate of 3.00%. The 3-month EUR/USD cross-currency basis is -60 bps, applied to the EUR leg in the convention where the basis is added to the EUR rate when lending EUR/borrowing USD. Approximately what annualized all-in USD rate does the bank pay by borrowing USD synthetically (borrowing USD via swap, lending EUR)?

The synthetic USD borrowing cost is about 5.60%. With a negative basis of 60 bps, the bank receives 60 bps less on its EUR leg, so its effective USD cost rises from the direct 5.00% by that amount. A positive-sign error would give 4.40%.

  1. A5.60%Correct
  2. B4.40%
  3. C5.00%
  4. D3.60%

Explanation

Under CIP the synthetic USD cost would equal 5.00%. A basis of -60 bps means the party obtaining USD through the swap effectively receives EUR interest 60 bps lower, so it pays 60 bps more in USD terms: 5.00% + 0.60% = 5.60%. Option B has the wrong sign; C assumes CIP holds.

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