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

A risk manager notes that the EUR/USD basis has become much more negative at each calendar quarter-end, particularly for swaps that span the reporting date, while the basis for contracts not spanning quarter-end is little changed. Which explanation best fits this pattern?

Quarter-end basis widening for spanning swaps reflects balance sheet constraints: banks facing leverage ratio reporting on quarter-end snapshots cut back FX swap arbitrage, which uses balance sheet capacity. Reduced arbitrage supply lets dollar demand push the basis more negative, a regulatory limit to arbitrage.

  1. ABanks subject to leverage ratio reporting at quarter-end shrink balance sheets and reduce arbitrage activity in FX swapsCorrect
  2. BInterest rate differentials between the euro area and the US widen mechanically at quarter-end
  3. CSpot exchange rates are fixed at quarter-end by central banks
  4. DCorporate dollar demand disappears at quarter-end, lowering the basis

Explanation

Arbitrage through FX swaps expands the balance sheet. Where leverage ratios are measured on quarter-end snapshots, banks cut such activity over the date, limiting arbitrage and widening the basis for spanning contracts. Rate differentials do not change in this way and reduced dollar demand would narrow, not widen, the basis.

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