Capital Constraints, Counterparty Risk, and Deviations from Covered Interest Rate Parity

Abstract

We provide robust evidence of deviations from the Covered Interest Parity (CIP) relation since the onset of the crisis in August 2007. The CIP deviations exist with respect to different dollar interest rates and exchange rate pairs of the dollar vis-a-vis other currencies. The results show that our proxies for margin conditions and cost of capital are significant determinants of the basis. Following the bankruptcy of Lehman Brothers, uncertainty about counterparty risk became a significant determinant of CIP deviations. The supply of dollars by the Federal Reserve to foreign central banks via reciprocal currency arrangements (swap lines) reduced CIP deviations. In particular, the announcement on October 13 2008 that the swap lines would become unlimited reduced CIP deviations substantially. These results indicate a breakdown of arbitrage transactions in the international capital markets during the crisis partly due to lack of funding and partly due to heightened counterparty credit risk. Central bank interventions helped to reduce the funding liquidity risk of global institutions.