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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 finds that swapping EUR into USD through FX swaps costs more than direct USD borrowing at the same rates would imply. Which factor best explains why arbitrageurs do not fully eliminate this deviation?

Balance sheet costs explain it. Closing the basis requires dealers to expand their balance sheets, and post-crisis leverage ratio and capital constraints make the small spread earned too low relative to those costs, so arbitrage capacity is limited and the deviation persists.

  1. AArbitrageurs are prevented by CIP from trading the forward market
  2. BBalance sheet costs from leverage ratio and capital rules make the arbitrage trade unattractive relative to its returnCorrect
  3. CSpot exchange rates are fixed by central banks
  4. DFX swaps are not available to non-US banks

Explanation

Arbitrage requires expanding the balance sheet by borrowing and lending. Post-crisis leverage ratio and other regulatory costs reduce the return per unit of balance sheet, so dealers do not close the gap. The other options are factually wrong.

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