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

Which difference best distinguishes a cross-currency basis swap from a short-term FX swap?

A cross-currency basis swap exchanges floating interest payments in two currencies over its life, usually for longer maturities, with the basis spread added to one leg. An FX swap embeds the interest differential in forward points and settles through spot and forward exchanges, mostly at short tenors.

  1. AA basis swap exchanges floating-rate interest payments in two currencies periodically and typically has longer maturity, with the basis added to one legCorrect
  2. BA basis swap has no principal exchange, while an FX swap always exchanges principal
  3. CA basis swap exposes the holder to unhedged spot exchange-rate risk at maturity
  4. DA basis swap is settled only at maturity through the forward points, with no interim payments

Explanation

Cross-currency basis swaps exchange principal at start and end and swap floating interest periodically, with the basis spread quoted on one leg, usually for longer tenors. FX swaps embed interest in forward points and are mostly short-dated. The other options misstate principal exchange, FX risk and settlement.

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