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

The 3-month USD interest rate is 2.00% per year and the 3-month EUR rate is 0.00% per year. A bank borrows EUR and swaps them into USD, and the implied USD rate from the swap is 2.60% per year (simple annualized). What is the cross-currency basis, and what does it mean?

The basis is -60 bp. The synthetic USD rate of 2.60% exceeds the direct 2.00% USD rate by 0.60%, so obtaining USD through the swap costs 60 bp more than direct borrowing, a deviation from covered interest parity.

  1. A-60 bp; the bank pays 60 bp more than direct USD borrowing to obtain USD via the swapCorrect
  2. B+60 bp; the bank earns 60 bp more than direct USD borrowing
  3. C-260 bp; the bank pays 260 bp more than the EUR rate
  4. D-200 bp; the bank pays the full interest differential

Explanation

The implied USD rate from the swap is 2.60% versus the direct USD rate of 2.00%, a gap of 0.60%. Obtaining USD synthetically is 60 bp more expensive, so the basis is -60 bp by convention. Taking 2.60% minus 0.00% gives 260 bp, which is the total swap cost rather than the deviation from CIP.

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