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

Which factor is most consistently cited as a driver of persistent negative cross-currency bases after the global financial crisis?

Persistent negative bases are mainly attributed to limited arbitrage capacity, as post-crisis regulation such as leverage constraints makes dealer balance sheets costly, combined with strong demand for dollars from non-US banks and investors. Arbitrageurs cannot fully close the gap, so the dollar premium persists.

  1. ARegulatory balance sheet constraints on dealers combined with strong demand for dollar funding from non-US institutionsCorrect
  2. BA sharp rise in arbitrage capacity as banks expanded leverage ratios
  3. CConvergence of global short-term interest rates to equal levels
  4. DElimination of foreign banks' reliance on dollar funding

Explanation

Post-crisis regulation such as leverage ratio requirements raised the cost of dealer balance sheet use, limiting arbitrage, while demand for dollar hedging and funding from non-US banks and investors stayed strong. Greater arbitrage capacity would shrink the basis, and equal rates would not remove CIP deviations.

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