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

Post-2008, the observed cross-currency basis for USD against EUR has frequently been negative. In terms of CIP, what does a negative basis imply for a euro-based institution that swaps EUR into USD?

A negative cross-currency basis means a euro-based institution pays more than the plain USD interest rate to raise dollars through FX swaps. This is a deviation from covered interest parity, reflecting heavy demand for dollar funding and limited balance sheet capacity for arbitrage.

  1. AIt receives a USD borrowing cost equal to the USD interest rate, with no premium
  2. BIt pays more than the USD interest rate to obtain USD through FX swaps, indicating a deviation from CIPCorrect
  3. CIt earns a premium over the USD interest rate because the EUR is in high demand
  4. DIt faces no deviation because the forward rate equals expected spot

Explanation

A negative basis means the implied USD cost via FX swaps or cross-currency swaps exceeds the direct USD rate, so CIP does not hold. The reason is strong demand for USD funding together with limits on arbitrage capacity. Receiving a premium or no deviation contradicts a nonzero basis.

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