Covered interest parity deviations in standard monetary models

Abstract

Several currencies have over time exhibited persistent deviations from covered interest rate parity (CIP), resulting in non-zero cross-currency basis swap spreads. The links between these deviations and macroeconomic variables, such as those in a standard monetary model, however, have attracted less interest. In this paper, we initiate attempts to address this gap. First, we present a simple model where we allow for deviations from CIP in a standard monetary framework. With this model, we argue for the existence of levels relationships between cross-currency basis swap spreads and the macroeconomic variables. In the empirical part, we employ long-panel techniques and show that tighter cross-currency swap spreads are related to a rise in relative money supply for both European and non-European currencies and to higher relative real output for non-European currencies. We also perform error-correction analysis which reveals that the mechanism governing the adjustment to equilibrium is not the same for European and non-European currencies. However, we show that a common theme between both groups is that when there is a move away from equilibrium, it is the cross-currency basis swap spreads that adjust to ensure a return to equilibrium.