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

Which of the following is a recognised limit to arbitrage that allows a negative cross-currency basis to persist after the global financial crisis?

Balance sheet costs are the key limit to arbitrage. Leverage ratio and capital rules make it costly for banks to expand balance sheets for FX swap arbitrage, so the return from exploiting a negative basis is too low, and the deviation from covered interest parity persists.

  1. ABanks' balance sheet costs from leverage and risk-weighted capital rules make FX swap arbitrage low-return relative to its costCorrect
  2. BCentral banks prohibit banks from trading FX swaps
  3. CForward contracts cannot be priced without a spot rate
  4. DInterest rates are identical across currencies

Explanation

Arbitrage trades using FX swaps and money market lending consume balance sheet. Post-crisis regulation and credit constraints make the small basis return insufficient, so the deviation persists. The other options are factually incorrect.

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