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

During the crisis, the cost of obtaining dollars through FX swaps rose sharply, with deviations from covered interest parity widening. What does this widening indicate about the dollar funding market?

The widening shows that obtaining dollars through FX swaps cost more than direct dollar rates implied. Dollar funding was scarce and arbitrageurs were constrained by balance sheet and credit limits, so covered interest parity broke down and the gap persisted.

  1. AArbitrageurs were freely exploiting parity gaps, which kept the gaps small
  2. BDollar borrowing via swaps became more expensive than direct dollar borrowing would imply, reflecting scarce dollar funding and limited arbitrage capacityCorrect
  3. CInterest rates in all currencies had converged to the same level
  4. DForeign exchange forward markets had been closed by regulators

Explanation

A widened covered interest parity deviation means synthetic dollar funding cost exceeded the cash rate, since balance sheet and credit constraints limited arbitrage and demand for dollars was high. Free arbitrage would have closed the gap, so the first option is wrong.

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