Stock market and deviations from covered interest parity

Abstract

In recent times, there has been a renewed interest in covered interest parity deviations wherein financial economists have begun to analyze the drivers of cross-currency basis swap spread, a measure of the extent of deviations from covered interest parity (CIP), for different currencies. They have, however, not examined how stock market index returns associate with changes in cross-currency basis swap spreads, especially in the case of the euro basis which is the most liquid among peers. This paper provides an empirical perspective on this new question. Using standard techniques, we examine how stock market index returns relate to changes in cross-currency basis in the eurozone. Consistent with our stylized model, the empirical results show that there is a positive relationship between changes in the basis and stock market index returns whereby wider (tighter) CIP deviations go hand-in-hand with declines (increases) in stock market index returns in the eurozone. This positive relation mostly holds up, though not always statistically significant, and its size varies across different empirical specifications.