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

A Japanese bank borrows US dollars by selling yen spot and buying yen forward through an FX swap. The one-year forward-implied dollar rate is higher than the dollar rate it could obtain in the cash market. Under the convention used in the covered interest parity literature, what is the sign of the cross-currency basis for the yen/dollar pair?

The basis is negative. By convention the basis equals the direct dollar rate minus the synthetic dollar rate implied by the FX swap. If swap-implied dollar funding costs more than cash dollar borrowing, the difference is below zero, signalling a premium for dollars and a CIP deviation.

  1. ANegative, because dollar borrowing through the swap costs more than the direct dollar rateCorrect
  2. BPositive, because dollar borrowing through the swap costs more than the direct dollar rate
  3. CZero, because the forward rate fully offsets interest differentials
  4. DNegative, because the yen interest rate exceeds the dollar interest rate

Explanation

The basis is defined as the deviation from CIP in the direct dollar rate minus the synthetic dollar rate from the swap. When synthetic dollar funding costs more than direct funding, the basis is negative. A zero basis would mean CIP holds, which contradicts the scenario.

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