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

A treasury analyst at a European bank observes that the cross-currency basis widened sharply negative at quarter-end while the interest rate differential was unchanged. Dealers with large balance sheets did not fully arbitrage the gap. Which explanation is most consistent with the limits-to-arbitrage argument in the reading?

Balance sheet constraints explain it. Closing the basis requires borrowing and lending in different currencies, which enlarges the balance sheet. Leverage ratio and similar regulatory costs peak at reporting dates, so dealers limit arbitrage and the basis stays wide.

  1. AArbitrage requires balance sheet space, and leverage ratio and other regulatory constraints at quarter-end make it costly for banks to expand itCorrect
  2. BArbitrage is riskless and capital-free, so dealers must have lacked information about the gap
  3. CCentral banks prohibit banks from lending dollars in the swap market at quarter-end
  4. DThe gap reflects expected exchange rate depreciation that arbitrageurs could not hedge

Explanation

Exploiting the basis involves borrowing in one currency and lending in another, which expands the balance sheet. Regulatory ratios, especially at reporting dates, raise the cost of this. Option D conflicts with the fact that the trade is covered, so it carries no exchange rate view.

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