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

Which observation about the cross-currency basis is most consistent with the empirical pattern after 2008, as the reading describes it?

The basis tends to widen around quarter-ends and year-ends, when banks face regulatory reporting dates and shrink balance sheets, reducing supply of synthetic dollar funding. This pattern fits balance sheet constraints as a driver of CIP deviations after 2008.

  1. AThe basis is typically widest at quarter-ends and year-ends for window-dressing banks facing balance sheet reporting datesCorrect
  2. BThe basis is always zero except during crises
  3. CThe basis widens when the dollar depreciates against all currencies
  4. DThe basis is unrelated to the strength of the dollar

Explanation

Reporting-date balance sheet constraints reduce dealers' willingness to supply dollars via swaps, so the basis widens around quarter- and year-ends. The basis is also related to dollar strength, which rules out the last two options, and it is persistently nonzero rather than only in crises.

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