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

A researcher argues that post-2008 CIP deviations persist because arbitrage capacity is constrained. Which combination of factors best supports this explanation, and why do the deviations tend to widen at quarter-ends?

Constraints on bank balance sheets, such as leverage ratios and capital requirements, make FX-swap arbitrage costly because it uses balance sheet for small returns. At quarter-ends banks window-dress to report smaller balance sheets, reducing arbitrage capacity further, so the basis widens.

  1. ABank balance-sheet and leverage-ratio constraints raise the cost of intermediating FX swaps, and window-dressing at reporting dates makes balance sheet scarcerCorrect
  2. BCentral banks banned forward contracts, and quarter-ends feature higher spot volatility only
  3. CInterest rate differentials vanished after 2008, and quarter-end effects arise from tax payments alone
  4. DCredit risk in FX forwards rose sharply because forwards lack any collateral, and quarter-ends bring margin calls on spot trades

Explanation

Post-crisis regulation (leverage ratio, higher capital) makes arbitrage trades, which are balance-sheet intensive with little profit per unit, less attractive. Banks reporting leverage at quarter-end shrink balance sheets, so the arbitrage capacity falls and basis widens. The other options cite facts that are false or unrelated.

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