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

Which statement best explains why persistent cross-currency basis deviations from covered interest parity can occur after the global financial crisis, with implications for treasury arbitrage?

Deviations persist because arbitrage requires balance sheet capacity, and post-crisis leverage and capital constraints make it costly for banks to exploit the gap. Dealers therefore demand compensation, leaving the basis open instead of being arbitraged to zero.

  1. AArbitrageurs face balance sheet and leverage constraints, so capital-cost-limited arbitrage cannot fully close the gapCorrect
  2. BForward contracts are no longer legally enforceable across jurisdictions
  3. CInterest rates in all currencies have converged, removing the incentive to arbitrage
  4. DCovered interest parity is a theory that applies only to emerging market currencies

Explanation

Post-crisis regulation and funding costs make bank balance sheet space costly, so dealers require compensation for taking the other side of the swap, leaving the basis open. The other statements are factually incorrect.

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