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

A cross-currency basis for EUR/USD is quoted at -40 bps on a 3-month horizon. A euro-based bank with surplus euros wants dollars. Which interpretation is correct?

A negative cross-currency basis of 40 bps means obtaining dollars through an FX swap against euros costs about 40 bps more than the direct dollar rate. It signals excess demand for dollar funding and a deviation from covered interest parity.

  1. AThe bank pays roughly 40 bps more than the direct USD rate to obtain dollars via the FX swap, reflecting dollar demandCorrect
  2. BThe bank earns 40 bps more than the direct USD rate by lending euros through the swap
  3. CThe bank pays 40 bps less because the euro is the stronger currency
  4. DThe negative basis means the forward rate equals spot minus 40 pips

Explanation

A negative basis means that borrowing dollars synthetically against euros costs more than the direct dollar rate, by about the size of the basis. This reflects a dollar shortage. The other options reverse the sign or confuse the basis with forward points.

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