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

Following the global financial crisis, covered interest parity deviations in the cross-currency basis became persistently large for several currencies against the US dollar. Which interpretation of a widening negative EUR/USD basis is most consistent with a dollar shortage?

A widening negative basis means that borrowing dollars synthetically through FX swaps costs more than covered interest parity implies. It signals excess demand for dollars, with limited arbitrage capacity from constrained bank balance sheets allowing the deviation to persist.

  1. ABorrowers of dollars via euro-dollar swaps pay a premium over the dollar rate implied by interest parity, reflecting excess demand for dollarsCorrect
  2. BEuro holders can earn a premium by lending dollars through swaps
  3. CDollar funding costs fall relative to euro funding costs
  4. DInterest parity holds more tightly because arbitrageurs expand balance sheets

Explanation

A more negative basis means that obtaining dollars through swapping euros costs more than the direct dollar rate implies. This signals excess demand for dollars. Arbitrage is limited by balance sheet constraints, so the deviation persists.

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