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FRM Part II · FRM Exam Part II · The US Dollar Shortage in Global Banking and the International Policy Response

Analysts note that the announcement of expanded Fed swap lines in a crisis often reduces the cross-currency basis (makes it less negative) even before large volumes are drawn. What is the best explanation?

The announcement acts as a credible dollar backstop. Banks and lenders expect dollars will be available at the swap line's price, so the scarcity premium embedded in FX swap markets falls and the basis narrows, even if little is actually drawn.

  1. AThe backstop lowers the perceived risk of being unable to obtain dollars, reducing the premium private lenders charge for dollar fundingCorrect
  2. BThe swap lines raise US Treasury yields, making dollar assets less attractive to hold
  3. CThe announcement forces foreign banks to repay all their dollar liabilities immediately
  4. DThe swap lines fix the exchange rate between the dollar and foreign currencies

Explanation

A credible lender-of-last-resort for dollars caps the price of dollar funding at the swap line rate plus a spread, so the premium for dollars in the FX swap market falls. The swap lines do not fix exchange rates, force repayment, or work by changing Treasury yields.

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