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

Which development would most likely lead to a more negative cross-currency basis against the US dollar, other things equal?

Higher demand for dollars from non-US institutions that fund dollar assets via FX swaps makes the basis more negative. Greater demand to borrow dollars synthetically pushes up the implied dollar rate, while easier arbitrage or lower demand would narrow the deviation.

  1. AA rise in the dollar funding demand of non-US banks that hold large dollar asset portfolios financed in local currency, and who hedge in FX swapsCorrect
  2. BA decline in the demand of foreign investors for hedged dollar assets
  3. CReduced regulatory costs of dealer balance sheet expansion
  4. DForeign institutional investors reducing dollar bond purchases

Explanation

Non-US banks financing dollar assets with local currency swap into dollars, pushing up demand to borrow dollars through FX swaps and widening the negative basis. The other options lower dollar demand or ease arbitrage, narrowing the basis.

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