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 currency swap is defined as the deviation of the observed forward-implied dollar rate from the direct dollar rate. Before 2008, how did the EUR/USD basis behave, and what changed after 2008?
The basis was roughly zero before 2008 because arbitrage kept CIP intact. After the crisis it turned persistently negative for major currencies against the dollar, so obtaining dollars synthetically through FX swaps cost more than borrowing dollars directly in the cash market.
- AIt was close to zero before 2008 and became persistently negative afterwards, meaning borrowing dollars via FX swaps cost more than direct dollar borrowingCorrect
- BIt was persistently positive before 2008 and turned to zero afterwards, as arbitrage capacity expanded
- CIt was close to zero before 2008 and became persistently positive afterwards, meaning borrowing dollars via FX swaps cost less than direct dollar borrowing
- DIt was persistently negative before 2008 and became zero afterwards because of central clearing
Explanation
Before the global financial crisis CIP held closely, so the basis was near zero. Afterwards, major-currency bases became persistently negative, so synthetic dollar funding through FX swaps or currency swaps was costlier than direct dollar borrowing. The positive-basis options reverse the sign of the post-crisis deviation.
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