FRM Part II · FRM Exam Part II · The US Dollar Shortage in Global Banking and the International Policy Response
A bank's treasurer observes that during the crisis the cost of obtaining dollars via FX swaps rose sharply, with the implied dollar rate from the swap far above the dollar LIBOR-type rate. What does this widening deviation indicate?
It indicates a dollar funding premium: covered interest parity broke down because demand for dollars via FX swaps surged while arbitrageurs and banks lacked the balance sheet or willingness to supply dollars, pushing the synthetic dollar borrowing cost above cash dollar rates.
- ACovered interest parity held more strongly than before the crisis
- BStrong excess supply of dollars in the swap market
- CA funding premium for dollars, meaning covered interest parity was violated because of dollar demand and limited balance sheet capacity to arbitrageCorrect
- DA decline in demand for dollars from non-US banks
Explanation
A rise in the cost of synthetic dollar funding above cash dollar rates reflects a dollar premium, a violation of covered interest parity driven by heavy dollar demand and constrained arbitrage capacity. Excess supply or stronger parity would imply the opposite.
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