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

During autumn 2008, a European bank that needed dollars used FX swaps (borrowing dollars against euros). Which observed market outcome most directly signaled the dollar shortage?

The cross-currency basis became sharply more negative, meaning obtaining dollars through FX swaps cost more than covered interest parity implies. This deviation reflected intense demand for dollars and limited arbitrage capacity, and it is the standard market signal of a dollar shortage.

  1. AThe cross-currency basis turned sharply more negative, so the cost of obtaining dollars via swaps exceeded that implied by covered interest parityCorrect
  2. BThe cross-currency basis turned positive, making dollars cheaper via swaps
  3. CCovered interest parity held more tightly than before the crisis
  4. DUS Treasury bill yields rose sharply because of reduced safe-asset demand

Explanation

A more negative basis means borrowers paying a premium to obtain dollars through swaps versus the rate implied by interest differentials, i.e., a covered interest parity deviation. Treasury bill yields actually fell on flight to safety, and parity broke down rather than tightened.

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