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

Which statement best describes the exchange of principal in a standard cross-currency basis swap, as opposed to a single-currency interest rate swap?

In a standard cross-currency basis swap the counterparties exchange notional principal at inception and swap it back at maturity at the original spot rate, while paying floating rates in each currency plus the basis spread. This fixed re-exchange rate is what hedges the FX exposure.

  1. APrincipal is exchanged at inception and re-exchanged at maturity at the initial spot rate, with floating payments in each currencyCorrect
  2. BNo principal is exchanged; only net interest differences are settled
  3. CPrincipal is exchanged only at maturity at the prevailing spot rate
  4. DPrincipal is exchanged at inception only, and the notional amortizes through interest payments

Explanation

A cross-currency basis swap exchanges notionals at the start and returns them at maturity at the original spot rate, with floating legs in each currency and the basis spread added to the non-USD leg. Interest rate swaps in a single currency do not exchange principal. Re-exchange at the prevailing spot rate would leave FX risk unhedged.

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