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Answer: The costs for arbitrageurs to finance their positions are increasingly reflected in the basis.
**Correct Answer: A** **Explanation:** After the global financial crisis, structural changes in how market participants price market, credit, counterparty, and liquidity risks tightened limits to arbitrage. As a result, arbitrage now incurs a persistent balance sheet cost. The costs for arbitrage participants to finance their offsetting positions are now being reflected in the FX swap basis, which explains the persistence of the positive cross-currency basis. **Why other options are incorrect:** - **B:** While credit value adjustments have been incorporated into pricing, arbitrage positions do not always eliminate counterparty risks. - **C:** Regulatory changes such as the Volcker rule have actually limited US banks' speculative proprietary trading activities, not increased them. - **D:** Liquidity risk costs still need to be priced into transactions by market participants, even though overall funding costs may have decreased. **Reference:** Claudio Borio, Robert McCauley, Patrick McGuire, Vladyslav Sushko, 2016. "Covered Interest Parity Lost: Understanding the Cross-Currency Basis," BIS Quarterly Review.
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A portfolio manager at a US-based hedge fund has been searching for potential return opportunities in the environment of declining global interest rates experienced after the global financial crisis (GFC) of 2007-2009. The manager identifies the existence of a positive cross-currency basis between two currencies and notes that this positive basis has persisted since the GFC. What is the most appropriate explanation for this persistence?
A
The costs for arbitrageurs to finance their positions are increasingly reflected in the basis.
B
The costs of credit value adjustments have increased, as arbitrage positions typically eliminate counterparty risks.
C
Regulatory changes have permitted an increase in US banks' speculative proprietary trading activities.
D
The addition of a liquidity risk cost to swap pricing is no longer required given the decline in the overall level of interest rates in the global economy.
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