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

During a dollar funding squeeze, the Federal Reserve activates a standing swap line with a foreign central bank, which lends dollars to its domestic banks. Which feature explains why this tool reduces the Fed's credit risk exposure?

The Fed's counterparty is the foreign central bank, not the commercial banks. It receives foreign currency in exchange for dollars and reverses at the original exchange rate, so there is no exchange rate risk, and the foreign central bank bears the credit risk of the banks it on-lends to.

  1. AThe Fed lends directly to foreign commercial banks and holds their loans as collateral
  2. BThe Fed exchanges dollars for foreign currency with the foreign central bank, which bears the credit risk of its banks, and the exchange is reversed at the original rateCorrect
  3. CThe Fed receives US Treasury securities from the foreign banks as collateral
  4. DThe Fed guarantees all foreign bank dollar liabilities in exchange for a fee

Explanation

In a swap line the Fed's counterparty is the foreign central bank, holding foreign currency as the counterpart of the dollars supplied, and the transaction reverses at the initial exchange rate, removing exchange rate risk. The foreign central bank takes the credit risk on its banks. Direct lending to foreign banks is not how the lines operate.

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