Skip to content

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

A European bank with surplus euros needs to fund a US dollar loan book. It borrows euros and swaps them into dollars through a one-year FX swap. Which of the following best describes the effect of a significantly negative EUR/USD cross-currency basis on this bank?

A significantly negative cross-currency basis makes synthetic dollar funding via FX swaps more expensive than the direct dollar rate implied by covered interest parity. The bank effectively pays a premium to obtain dollars against euros, which raises its dollar funding cost and signals a dollar shortage.

  1. AThe effective cost of raising dollars through the FX swap is higher than the dollar cash-market rate implied by covered interest parityCorrect
  2. BThe effective cost of raising dollars through the FX swap is lower than the dollar cash-market rate implied by covered interest parity
  3. CThe bank earns a risk-free arbitrage profit by borrowing dollars directly and lending euros
  4. DThe basis only affects the bank's euro funding costs and leaves its dollar funding costs unchanged

Explanation

A negative basis means the party lending dollars through the swap pays/receives less on the euro leg, so the bank raising dollars synthetically pays a premium over the direct dollar rate. The bank's synthetic dollar funding is therefore more expensive than covered interest parity would imply. The second option reverses the sign of the effect.

Did you get it right without looking?

One question tells you little. A timed set on Covered Interest Parity Lost: Understanding the Cross-Currency Basis shows your real accuracy, how long you take and where you lose marks.

Practise Covered Interest Parity Lost: Understanding the Cross-Currency BasisFree diagnostic mock

More Covered Interest Parity Lost: Understanding the Cross-Currency Basis questions