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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), the cross-currency basis in a currency swap is defined as the deviation from parity. A negative USD cross-currency basis on EUR/USD, as observed since the global financial crisis, most directly implies which of the following for a bank borrowing US dollars through FX swaps?

A negative USD cross-currency basis means that raising dollars synthetically through FX swaps costs more than borrowing dollars directly in the money market. The bank therefore pays a premium for dollar funding, reflecting excess demand for dollars relative to the supply of arbitrage capital.

  1. AThe bank pays a premium over the direct USD money market rate to obtain dollars syntheticallyCorrect
  2. BThe bank obtains dollars synthetically at a discount to the direct USD money market rate
  3. CThe bank earns a positive spread for lending euros in the swap
  4. DThe forward EUR/USD rate must equal the spot rate

Explanation

A negative basis means the implied USD rate from swapping euros exceeds the direct USD rate, so borrowing dollars through the swap is more expensive. Hence the borrower pays a premium. The other options reverse the sign or misstate the forward relationship.

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