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

A Japanese bank funds a USD 2 billion portfolio of USD assets with rolling 3-month FX swaps (borrowing USD, lending JPY). The 3-month USD/JPY basis is -50 bps annualized. Ignoring other costs, what is the approximate additional cost over one quarter relative to funding at the direct USD rate, and what is the key liquidity risk?

The extra cost is about USD 2.5 million per quarter, being USD 2 billion times 0.50% divided by four. The main liquidity risk is rollover risk, because the short-dated swap must be renewed at a basis that can widen sharply, raising costs or limiting USD access.

  1. AUSD 2.5 million; the basis may widen at rollover, raising costs or restricting availability of USDCorrect
  2. BUSD 10 million; the basis may narrow at rollover, raising costs
  3. CUSD 2.5 million; there is no risk because the swap hedges the exchange rate fully for the period
  4. DUSD 1 million; the risk is that JPY interest rates become negative

Explanation

Annual extra cost = 2,000m x 0.50% = USD 10m; one quarter is a quarter of that, USD 2.5m. Option B forgets to adjust for the quarter. The key liquidity risk is rollover: the swap hedges FX at maturity but must be renewed at the prevailing basis, which may widen in stress.

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