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

A treasury analyst notes that the cross-currency basis typically widens sharply at quarter-ends and especially year-ends for banks subject to leverage ratio reporting. What is the most appropriate interpretation?

Period-end window-dressing reduces dealer balance sheet capacity for FX swap and repo intermediation, so CIP arbitrage becomes costlier at quarter-ends and year-ends. The dollar funding premium rises, and the negative cross-currency basis widens temporarily.

  1. AWindow-dressing reduces dealer balance sheet capacity at reporting dates, making FX swap arbitrage costlier and increasing the dollar premiumCorrect
  2. BInterest rate parity momentarily strengthens because of month-end rebalancing of index funds
  3. CDollar demand falls at year-end, causing the basis to become less negative
  4. DCentral banks suspend swap lines at reporting dates, which removes the basis

Explanation

Banks that report leverage ratios on period-end snapshots shrink balance sheet activity such as repo and FX swap intermediation at those dates, so arbitrage capacity falls and the dollar premium rises, widening the negative basis. The other options contradict this evidence.

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