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

A treasurer at a euro-based bank wants to borrow US dollars for three months by pledging euros as collateral-like funding through an FX swap. Under covered interest parity (CIP) holding exactly, which statement best describes the implied dollar borrowing cost through the swap?

When covered interest parity holds, the dollar rate implied by an FX swap equals the direct dollar borrowing rate, so the cross-currency basis is zero. The forward points exactly offset the interest rate differential, leaving no arbitrage gap between the two ways of raising dollars.

  1. AIt equals the direct dollar cash borrowing rate, so the cross-currency basis is zeroCorrect
  2. BIt equals the euro interest rate plus the spot-forward premium, plus a positive basis
  3. CIt is always lower than the direct dollar rate because the euros act as collateral
  4. DIt equals the dollar rate only if the forward rate equals the spot rate

Explanation

Under CIP, the FX-swap-implied dollar rate equals the direct dollar cash rate, so the basis is zero. The forward premium or discount offsets the interest differential. Forward equal to spot would only hold if rates were equal across the two currencies.

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