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

A euro-based bank needs USD funding and compares two routes: borrowing USD directly in the cash market, or borrowing EUR and swapping into USD through a one-year FX swap. The cross-currency basis for EUR/USD is quoted at -30 bps. Which statement best describes the implication for the bank's cost of synthetic USD funding?

A negative cross-currency basis of -30 bps means the bank pays about 30 basis points more for synthetic USD funding than covered interest parity implies, because demand for dollars via swaps pushes up the implicit dollar borrowing cost.

  1. ASynthetic USD funding is cheaper by about 30 bps than the direct USD rate implied by covered interest parity
  2. BSynthetic USD funding costs about 30 bps more than the USD rate implied by covered interest parityCorrect
  3. CThe basis has no effect on the cost because the forward rate offsets it exactly
  4. DSynthetic USD funding costs 30 bps less than EUR funding

Explanation

A negative EUR/USD basis means that those who lend EUR and borrow USD via swaps pay a premium over the USD rate implied by covered interest parity. Hence a euro-based bank raising USD synthetically pays roughly 30 bps extra. Option A reverses the sign, and option C assumes CIP holds, which the basis says it does not.

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