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

Under covered interest parity (CIP) as it held before the global financial crisis, the cross-currency basis on a EUR/USD currency swap should have been approximately:

Under covered interest parity the basis is approximately zero, because the forward premium or discount exactly offsets the interest rate differential. Swapping borrowing into another currency then costs the same as borrowing directly, so no riskless arbitrage profit remains.

  1. AZero, because the forward premium offsets the interest rate differentialCorrect
  2. BEqual to the difference between the two countries' inflation rates
  3. CEqual to the bid-ask spread of the spot exchange rate
  4. DAlways negative, because the US dollar is the funding currency

Explanation

CIP says that borrowing in one currency and swapping into another through the forward market should cost the same as borrowing directly. The forward premium therefore offsets the interest differential and the basis is about zero. The negative-basis option describes the post-crisis pattern, not CIP.

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