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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 on a EUR/USD FX swap is defined as the deviation from parity. Which statement best describes the convention used when the basis is negative, as observed for the euro and yen against the dollar since 2008?

A negative cross-currency basis means that raising dollars synthetically, by borrowing euros or yen and swapping them into dollars, costs more than borrowing dollars directly. This premium is the deviation from covered interest parity that has persisted since 2008.

  1. ABorrowing dollars through the FX swap market costs more than borrowing dollars directly in the cash marketCorrect
  2. BBorrowing dollars through the FX swap market costs less than borrowing dollars directly in the cash market
  3. CForward and spot exchange rates are identical
  4. DInterest rates in the two currencies are equal

Explanation

A negative basis means the implied dollar rate from swapping euros or yen into dollars exceeds the direct dollar rate. Dollar borrowers via the swap thus pay a premium over direct dollar funding. The second option reverses the sign of the deviation.

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