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

Research on the post-crisis basis finds that deviations tend to widen at quarter-ends, especially for banks subject to leverage ratio reporting. What is the most plausible reason?

Banks facing leverage ratio reporting at quarter-ends reduce low-margin, balance sheet intensive trades, including CIP arbitrage. That cuts dealer supply of USD in FX swaps while demand continues, so the basis widens at those dates.

  1. ASpot exchange rates become illiquid at quarter-ends
  2. BWindow-dressing banks shrink low-return balance sheet activities such as arbitrage at reporting dates, reducing dealer supply of USD in swapsCorrect
  3. CCentral banks stop providing USD swap lines at quarter-ends
  4. DInterest rate differentials change mechanically at quarter-ends

Explanation

Banks measured on period-end balance sheets cut low-margin, balance sheet intensive trades like CIP arbitrage at reporting dates. This reduces supply of USD in the swap market and widens the basis. The other options have no basis in the reading.

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