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

A Japanese life insurer holds US Treasuries and hedges the currency risk by rolling three-month FX swaps, selling USD forward. If the cross-currency basis becomes more negative, what is the effect on the insurer's hedged yield?

The hedged yield falls. Hedging by rolling FX swaps means the investor effectively raises the currency through the swap market, and a more negative basis raises that cost, reducing the yield pickup from the foreign bond after hedging.

  1. AHedged yield falls because the cost of obtaining yen against dollars risesCorrect
  2. BHedged yield rises because forward dollars sell at a premium
  3. CHedged yield is unchanged because the hedge removes all rate risk
  4. DHedged yield rises because the insurer lends dollars at the higher basis

Explanation

The insurer effectively lends yen and borrows dollars? It receives yen at the forward and effectively funds in dollars, so it is a dollar supplier through the swap. Actually it lends dollars in the swap to obtain yen; a more negative basis means dollar borrowers pay more, so the hedger lending dollars gains... However, a Japanese investor hedging by selling USD forward is exchanging USD for JPY spot-forward, effectively borrowing yen and lending dollars in the swap only if reversed. In the standard hedge the investor borrows dollars against yen at the start of each period, pays the basis, and so hedged yield falls.

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