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

A bank's 3-month euro/dollar FX swap implies a dollar borrowing cost 90 bps above the rate predicted by covered interest parity using a 3-month euro rate of 1.00% and a dollar rate of 2.00% (annualised, simple). During the crisis the cross-currency basis widened to -90 bps. Which statement best interprets this?

A basis of -90 bps means banks raising dollars via euro-dollar swaps pay roughly 90 bps more than interest parity implies. This deviation from covered interest parity reflects scarce dollar funding and balance sheet constraints on arbitrageurs, so it indicates a dollar shortage.

  1. ABorrowing dollars through swaps by pledging euros costs about 90 bps more than interbank dollar rates imply, signalling a dollar shortageCorrect
  2. BEuro borrowers earn a 90 bps premium for lending euros in swaps, signalling a euro shortage
  3. CCovered interest parity holds perfectly because the swap is hedged
  4. DThe basis shows only credit risk on US Treasuries

Explanation

A negative basis on the euro leg means those obtaining dollars against euros pay a premium beyond the interest differential. This is a deviation from covered interest parity reflecting dollar scarcity and limits to arbitrage, so it signals shortage rather than euro scarcity.

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