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

In a standard FX swap used by a euro-based bank to raise dollars for one year, which description of the cash flows is correct?

The bank sells euros spot to receive dollars and simultaneously contracts to buy euros back at a forward rate fixed today. The forward points embed the interest differential and any basis, so FX risk is hedged and no periodic interest payments are exchanged.

  1. AIt sells euros spot for dollars and agrees to buy euros back at a pre-agreed forward rate at maturityCorrect
  2. BIt buys euros spot with dollars and agrees to sell euros forward, with periodic interest exchanged
  3. CIt exchanges euro and dollar principal at spot and re-exchanges at the spot rate prevailing at maturity
  4. DIt receives dollars spot and pays only the interest differential at maturity with no principal exchange

Explanation

An FX swap combines a spot exchange and an opposite forward exchange at a rate fixed today, so the exchange-rate risk is removed. Re-exchange at the future spot rate would leave FX risk open, and there is no periodic interest, since the forward points embed the interest differential.

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