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

Which regulatory or market development is most closely linked in the literature to the persistence of a non-zero cross-currency basis after the global financial crisis, with implications for bank treasury practice?

Balance sheet constraints on dealer banks, such as leverage ratio rules, reduce their capacity to arbitrage away covered interest parity deviations. Because arbitrage is costly, the cross-currency basis persists, and treasurers must plan for USD funding costs that can spike around reporting dates.

  1. ABalance sheet constraints on dealer banks, such as leverage ratio requirements, limit arbitrage capacityCorrect
  2. BThe elimination of FX swap markets for major currencies
  3. CA decline in global demand for USD funding by non-US banks
  4. DMandatory fixed exchange rates among major currencies

Explanation

After the crisis, regulations like leverage ratios and funding constraints made it costly for dealers to expand balance sheets for arbitrage, so deviations from CIP persisted, particularly at quarter-ends. The other options contradict observed facts: swap markets remain large, demand for USD remains strong, and major currencies float.

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