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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 USD/EUR currency swap is defined as the deviation from parity. Which statement correctly describes a negative EUR/USD basis as observed after the global financial crisis?

A negative EUR/USD basis means obtaining dollars through the FX swap market costs more than the direct dollar borrowing rate. The implied dollar rate exceeds the cash rate, reflecting strong demand for dollar funding, so covered interest parity is violated.

  1. ABorrowing US dollars via FX swaps costs more than borrowing dollars directly in the cash market, so the implied dollar rate is above the direct dollar rateCorrect
  2. BBorrowing US dollars via FX swaps costs less than borrowing dollars directly in the cash market, so the implied dollar rate is below the direct dollar rate
  3. CEuro borrowers can raise dollars synthetically more cheaply than US dollar cash borrowing rates would imply
  4. DThe forward premium on the euro is exactly equal to the interest rate differential

Explanation

A negative basis means the implied dollar rate from swapping euros into dollars exceeds the direct dollar interest rate. Holders of euros pay a premium to obtain dollars, so CIP fails. Option B reverses the sign, and D describes CIP holding.

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