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

A European bank needs USD funding and compares borrowing USD directly in the cash market with raising EUR and swapping into USD through FX swaps. The EUR/USD cross-currency basis is quoted at -40 bps. Relative to the direct USD rate, what does this basis imply for the swap route?

A -40 bp EUR/USD basis means borrowing USD synthetically through an FX swap costs about 40 bps more than borrowing USD directly. The negative basis is a premium for USD funding, reflecting a deviation from covered interest parity.

  1. ASynthetic USD funding via the FX swap costs roughly 40 bps more than direct USD borrowingCorrect
  2. BSynthetic USD funding via the FX swap costs roughly 40 bps less than direct USD borrowing
  3. CSynthetic USD funding costs the same because covered interest parity always holds
  4. DSynthetic USD funding is cheaper only for borrowers with AAA ratings

Explanation

A negative basis on EUR/USD means that a party lending EUR and borrowing USD through the swap pays a premium over the direct USD rate. Here the extra cost is about 40 bps. Option B reverses the sign, and C assumes CIP holds, which is the very deviation the basis measures.

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