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

Before the global financial crisis, covered interest parity held closely for major currency pairs. Which feature of the arbitrage explains why it was expected to hold?

Before the crisis, covered interest arbitrage was nearly riskless and used little scarce capital, so banks could scale it until deviations vanished. After the crisis, leverage and capital constraints made balance sheet costly, which let the cross-currency basis persist.

  1. AArbitrage required large amounts of bank balance sheet capacity that was costless to use
  2. BArbitrage was a near riskless, low-capital trade that banks could scale until deviations disappearedCorrect
  3. CCentral banks fixed forward rates to equal interest differentials
  4. DForward contracts carried substantial default risk that offset any gain

Explanation

Pre-crisis, banks faced few balance sheet constraints and funding was cheap, so the covered trade could be scaled until any deviation vanished. Post-crisis leverage and capital rules raised the cost of such trades, allowing persistent bases.

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