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

A bank's treasurer observes that the one-year EUR/USD basis is -50 bp and the bank can lend dollars via an FX swap while borrowing dollars directly at the USD rate. Another institution holds a large euro-denominated high-quality bond portfolio and could swap into dollars. Which statement best explains why the persistent basis is not arbitraged away by well-capitalised banks, as discussed in the post-crisis literature?

The basis persists because arbitrage consumes scarce balance sheet capacity. Post-crisis leverage ratio and capital constraints make the hedged trade costly for banks even though it appears riskless, so limits to arbitrage combined with imbalanced dollar demand allow deviations from covered interest parity to remain.

  1. ABalance sheet costs, such as leverage ratio and capital requirements, make the arbitrage trades unattractive even though they appear risklessCorrect
  2. BCovered interest parity holds exactly after the crisis, so the basis is only a measurement error
  3. CCentral banks forbid banks from trading FX swaps with each other
  4. DThe arbitrage requires taking large unhedged exchange rate risk

Explanation

The arbitrage is hedged, so FX risk is not the issue. Regulatory balance sheet constraints (leverage ratio, G-SIB surcharges, window-dressing at reporting dates) raise the effective cost of the arbitrage trade, so limited arbitrage capital allows the basis to persist. The claim that parity holds exactly contradicts the reading.

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