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

Quarter-end regulatory balance sheet constraints cause dealers to reduce FX swap intermediation. Which outcome is most consistent with the cross-currency basis literature for a one-month EUR/USD swap spanning the quarter-end?

The basis typically becomes more negative for short maturities spanning quarter-end. Balance-sheet-based regulation makes dealers reluctant to intermediate, which reduces arbitrage capacity that would otherwise close deviations from covered interest parity, so the premium on borrowing dollars through swaps rises.

  1. AThe basis widens (more negative) for the maturity spanning quarter-end, as arbitrage capacity fallsCorrect
  2. BThe basis narrows toward zero because fewer participants lessen demand for dollars
  3. CThe basis is unaffected because arbitrage is riskless and capital-free
  4. DThe basis turns positive because euro lenders earn a premium

Explanation

Arbitrage that would close basis deviations consumes balance sheet, and leverage ratio reporting at quarter-end makes it costly for dealers. With less arbitrage capacity and persistent dollar demand, deviations from covered interest parity widen for tenors spanning the reporting date. Arbitrage is therefore not capital-free.

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