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

A dealer notes that CIP deviations have persisted since 2008 even though the arbitrage appears riskless. Which explanation is most consistent with the reading's account of why arbitrageurs do not eliminate the basis?

The basis persists because arbitrage uses scarce bank balance sheet. Post-crisis leverage and capital constraints make exploiting small deviations unattractive, while structural demand for dollar funding and hedging remains strong. The trade is hedged, so unhedged currency risk is not the explanation.

  1. AForward contracts cannot be traded across currencies
  2. BCentral banks fix the basis by regulation
  3. CPost-crisis balance sheet constraints and capital costs on banks make the arbitrage unattractive relative to its small return, while demand for dollar hedging is strongCorrect
  4. DThe arbitrage carries large unhedged currency risk

Explanation

After 2008, leverage and capital regulation raised the cost of balance sheet use, so arbitrage returns became too low per unit of constrained capital, while demand for synthetic dollars (e.g., from investors hedging) persisted. Currency risk is hedged in CIP arbitrage, so the last option is wrong.

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