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

According to the reading, why have central bank swap lines tended to reduce the size of the negative cross-currency basis during periods of acute dollar shortage?

Swap lines provide foreign banks dollars through their central banks at a set price, creating a ceiling on what they will pay in the FX swap market. This eases dollar shortages and limits how negative the cross-currency basis can become.

  1. AThey give foreign banks access to dollars at a known price, which caps the premium paid in the market for dollarsCorrect
  2. BThey eliminate all regulatory costs of dealer balance sheet use
  3. CThey remove foreign banks' need to hold dollar assets
  4. DThey raise the dollar interest rate relative to other currencies

Explanation

Swap lines let foreign central banks lend dollars to their banks at a fixed spread over OIS, so market premiums above that level are capped. They do not remove regulation or dollar assets and do not raise the dollar rate.

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