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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 asset portfolio by rolling 3-month FX swaps. A treasurer notes the cross-currency basis widens sharply at quarter-end and in times of stress. Which is the most important liquidity risk implication of this funding approach?

The key implication is rollover risk. Funding USD assets with short-term FX swaps means the bank must repeatedly renew them, and a widening basis or reduced dollar availability at quarter-end or in stress can raise costs or block funding.

  1. ARollover risk, as the bank may face higher swap costs or reduced availability when renewing the short-dated swapsCorrect
  2. BCredit risk on the USD assets is eliminated by the swap
  3. CInterest rate risk is removed because the swap fixes the term premium
  4. DSettlement risk disappears since the swap is collateralized by yen deposits

Explanation

Funding long-dated USD assets using short-dated swaps creates a maturity mismatch. When the basis widens or counterparties pull back, the roll becomes costlier or unavailable, which is a rollover and funding liquidity risk. The other options assert risks are eliminated, which a swap does not do.

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