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FRM Part II · FRM Exam Part II · The US Dollar Shortage in Global Banking and the International Policy Response

A European bank holds a large portfolio of US dollar-denominated loans and securities but has few US retail deposits. It funds the shortfall by borrowing euros in the money market and swapping them into dollars through short-term FX swaps. Which statement best describes the key risk in this funding structure?

The main risk is rollover risk. The bank funds long-term dollar assets with short-term FX swaps that must be renewed repeatedly, so if dollar funding becomes scarce or expensive, it cannot refinance its dollar positions, even though the currency exposure is nominally hedged.

  1. ARollover risk: the swaps must be renewed repeatedly, and if dollar funding dries up or becomes costly the bank cannot refinance the dollar assetsCorrect
  2. BCredit risk on the dollar loans is eliminated because the swap hedges the borrower's default
  3. CInterest rate risk is the only exposure because the swap exchanges the currencies at a fixed rate
  4. DSettlement risk disappears because swaps are not exchanged at maturity

Explanation

The dollar assets are long-dated while the dollar funding obtained via FX swaps is short-term, so the bank must keep renewing the swaps. If the market stresses, the swaps may be unavailable or very expensive. The other options misdescribe what an FX swap hedges.

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