Deviations from Covered Interest Rate Parity

Abstract

We find that deviations from the covered interest rate parity condition imply large, persistent, and systematic arbitrage opportunities in one of the largest asset markets in the world. Contrary to the common view, we show that these deviations for major currencies are not explained away by credit risk or transaction costs. Furthermore, these deviations are highly correlated with nominal interest rates in the cross section and in the time series, higher at quarter ends post-crisis, significantly correlated with other fixed-income spreads, and much lower after proxying for banks’ balance sheet costs. These empirical findings point to key frictions in financial intermediation and their interactions with global imbalances during the post-Global Financial Crisis period.