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

Which explanation best fits the post-2008 persistence of CIP deviations, rather than their quick elimination by arbitrageurs?

Post-crisis regulation and balance sheet constraints, such as the leverage ratio, make CIP arbitrage costly for dealer banks, while demand for dollar funding is imbalanced. Arbitrage capacity is therefore limited, so the deviations persist instead of being eliminated.

  1. ABalance sheet constraints from post-crisis bank regulation, such as leverage ratio requirements, raise the cost of the arbitrage, combined with imbalanced demand for dollar fundingCorrect
  2. BInterest rate differentials between countries have vanished, so forward points no longer carry information
  3. CCentral banks have banned forward contracts in major currencies
  4. DArbitrage became risk-free and cheaper, so it is fully exploited and the remaining basis is only measurement noise

Explanation

CIP arbitrage uses bank balance sheets and is therefore costly when leverage ratio and similar constraints bind, particularly at reporting dates, while strong demand for dollar hedging and funding pushes the basis. The other options are factually incorrect or contradict the persistence of the deviations.

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