FRM Part II · FRM Exam Part II · Covered Interest Parity Lost: Understanding the Cross-Currency Basis
A Japanese institution has USD 100 million of assets to fund for one year. The direct USD rate is 5.00%, the yen rate is 1.00%, and the spot rate is JPY 150 per USD. The CIP-implied forward is 150 x (1.01/1.05) = JPY 144.2857. The market forward is JPY 143.5714 per USD, which is the rate at which the institution sells dollars and buys yen at maturity as part of the hedged cash flows. Using the market forward, the institution borrows yen, converts to dollars at spot, and hedges the repayment by buying yen forward against dollars. What is the approximate effective annual USD cost of this synthetic dollar funding?
The effective cost is about 5.5%. Repaying JPY 15,150 million at a forward of 143.5714 requires about USD 105.53 million, versus USD 100 million borrowed. That is roughly 50 bp above the 5.00% direct rate, which is the cross-currency basis.
- AAbout 5.50%Correct
- BAbout 4.50%
- CAbout 5.00%
- DAbout 6.00%
Explanation
Borrow JPY 15,000 million, giving USD 100 million at spot. Repay JPY 15,150 million. Buying yen forward at the stated rate costs 15,150/143.5714 = USD 105.527 million at maturity, so the effective USD rate is about 5.53%, roughly 5.50%. Under the CIP forward, the cost would be 15,150/144.2857 = USD 105.0 million, which is 5.00%. The basis is therefore about -50 bp.
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