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

In a standard cross-currency basis swap, which feature is correct?

A cross-currency basis swap exchanges principal at inception and re-exchanges it at maturity at the same initial spot rate, with floating payments in each currency and a basis spread on one leg. Fixing the exchange rate removes FX risk on principal.

  1. ATwo parties exchange principal at the start and re-exchange at maturity at the initial spot rate, with periodic floating payments in each currency and the basis added to one legCorrect
  2. BOnly interest payments are exchanged, with no principal exchange
  3. CPrincipal is re-exchanged at the then-prevailing spot rate at maturity
  4. DBoth legs pay fixed rates in their own currency and no basis applies

Explanation

A cross-currency basis swap exchanges notionals at the initial spot rate, swaps floating-rate payments in the two currencies with a spread (the basis) on one leg, and re-exchanges notionals at the same initial rate. Re-exchanging at the future spot would leave FX risk, which the swap is designed to remove.

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