Covered Interest Parity Research Articles

Quantities and Covered-Interest Parity

Studies of intermediated arbitrage argue that bank balance sheets are an important consideration, yet little evidence exists on banks’ positioning in this context. Using confidential supervisory data (covering $25 trillion in daily notional exposures) we examine banks’ positions in connection with covered-interest parity (CIP) deviations. Exploiting cross-sectional variation in CIP deviations that have largely challenged existing theories, we document three novel forces that drive bases: 1) foreign safe asset scarcity, 2) market power and segmentation of banks specializing in different markets, and 3) concentration of demand. Our findings shed empirical light on the interplay of frictions influencing banks’ provision of dollar funding.

Quantities and Covered-Interest Parity

Quantities and Covered-Interest Parity

Quantities and Covered-Interest Parity

Quantities and Covered-Interest Parity

Original sin redux and deviations from covered interest parity

Emerging markets (EMs) have increasingly turned to international capital borrowing in their local currencies (LC), leading to considerable LC external debts, particularly after the 2007 global financial crisis. Our study shows that this rise in LC external debts results in more significant deviations from the covered interest rate parity (CIP) between EMs and the US. This phenomenon is primarily attributed to a shift of currency mismatch risk and specific transaction costs from EM borrowers to international investors. As a result, EMs encounter elevated funding costs in comparison to the US, since investors seek higher returns to offset the added risks and expenses linked to LC external debts. Our analysis further underscores that the influence of LC external debts on amplifying CIP deviations is especially notable in EMs marked by substantial currency mismatch risks, such as those with floating exchange rate systems, heightened inflation risks, and significant currency depreciations. Moreover, the presence of stringent capital controls and limited debt market liquidity, which signify high transaction costs, intensify these effects.

Cross-currency basis swap spreads and corporate dollar funding

This study examines the failure of covered interest parity (CIP) in long-term cross-currency basis swap (CCBS) markets. We conjecture that frictions in corporate bond markets urge firms to raise funds in one market and enter a CCBS contract to exchange the debt in a different currency. Therefore, frictions in the corporate bond market explain the failure of CIP in the long-term CCBS market. We illustrate this idea using a simple theoretical model and then explore the determinants of CCBS spreads, and demonstrate the links between corporate funding needs and the long-term CCBS market. Furthermore, we show that frictions (illiquidity in the banking sector) and credit risk are essential drivers of CCBS spreads during economic stress.

Deviations from covered interest parity in the emerging markets after the global financial crisis

In this paper, we focus on six emerging market economies to study the magnitude of systemic and persistent deviations from covered interest parity (CIP) using daily data between January 2010 and July 2018. We show the significant role of local factors, particularly credit and liquidity risk, in explaining sustained CIP deviations in these markets. Our findings suggest that the impact of credit risk on CIP deviations in emerging market economies may take two forms. In low-carry currencies, the well-known mechanism for credit risk operates so that the increase in credit risk exacerbates CIP deviations. Conversely, in high-carry currencies, the high usage of foreign exchange swaps makes swap rates react more than domestic rates, which causes CIP to decrease. We also present evidence that cost of illiquidity is an important driver to explain CIP deviations. We demonstrate that increased liquidity in emerging market currencies is not as large to prevent CIP deviations.

The Perfect Storm: Bank of Israel's Forex Interventions, Global Banks' Limited Risk-Bearing Capacity, Deviations from Covered Interest Parity, and the Impact on the USD/ILS Options Market

The Perfect Storm: Bank of Israel's Forex Interventions, Global Banks' Limited Risk-Bearing Capacity, Deviations from Covered Interest Parity, and the Impact on the USD/ILS Options Market

Explaining Apparent deviations from Covered Interest Parity: Evidence from Mexico

This paper tests and quantifies the effects of reduced funding liquidity conditions on the covered interest parity (CIP) relating the U.S. Dollar-Mexican Peso market. To this end, a vector error-correction model is estimated. Results suggest, first, that apparent deviations from the CIP disappear when measures of funding liquidity for market participants are considered. Second, the exchange rate forward premium and the U.S. interest rate adjust towards the CIP cointegrating relationship. Finally, a structural analysis shows that deviations from CIP are mostly determined by shocks on the funding liquidity in the U.S. while funding liquidity conditions in Europe also have a non-negligible role. From the policy perspective, the paper underlies the relevance of funding liquidity measures when assessing whether the foreign exchange market works efficiently. As ever, there are some caveats in the analysis to consider. First, funding liquidity measures may shift from non- to stationary regimes. Second, market participants may not able to fund their liquidity at reference rates. The financial series present considerable ARCH-like behaviour, this may be a source of information to explore in further work.

Currency denomination and borrowing cost: Evidence from global bonds

Global bonds are debt securities placed in multiple markets with globally connected trading and clearing mechanisms. This paper studies the relation between global bond issuers’ currency denomination decisions and prevailing borrowing costs. The results show that issuers of these globally fungible debt instruments make currency denomination decisions that are inconsistent with a belief in either covered or uncovered interest parity. Supranational institutions and borrowers from advanced economies exhibit a stronger tendency to engage in this type of opportunistic behavior than emerging economy borrowers. Furthermore, global bond borrowers respond more strongly to deviations from covered interest parity after the 2008 global financial crisis.

US monetary policy uncertainty and RMB deviations from covered interest parity

This paper examines how US monetary policy uncertainty (MPU) affects RMB deviations from covered interest parity (CIP) and how this effect is influenced by China’s capital controls, the RMB exchange rate regime, and international reserves that constrain the transmitting channel of US MPU shocks. Our findings show that US MPU has a spill-over effect and creates deviations from RMB CIP. Capital controls insulate uncertainty shocks and alleviate the US MPU spill-over effect. There are some evidence that international reserves alleviate and the liberalised RMB exchange rate regime magnifies the spill-over effect. However, their effects become insignificant in the presence of capital controls. Moreover, the US MPU effect on RMB CIP deviations becomes prominent after the 2008 global financial crisis.

Covered Interest Parity Arbitrage

Abstract To understand deviations from covered interest parity (CIP), it is crucial to account for heterogeneity in funding costs across both banks and currency areas. For most market participants, the no-arbitrage relation holds fairly well when implemented using marginal funding costs and risk-free investment instruments. However, a few high-rated banks do enjoy CIP-arbitrage opportunities. Dealers avert inventory imbalances stemming from lower-rated banks’ usage of FX swaps to obtain dollar funding by inducing opposite (arbitrage) flows from high-rated banks. Arbitrage trades are difficult to scale, however, because funding costs increase as soon as arbitrageurs increase positions. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

The dollar’s ”Convenience Yield”

I link deviations from forward-spot parity for currencies and commodities. The key is to think of the U.S. dollar as a “commodity.” When commodity spot prices are too high compared to futures, arbitrageurs will short the commodity and bank dollars. When physical scarcity constrains commodity borrowing, the result is a positive convenience yield. In the currency space, it is the dollar itself that needs to be shorted, with proceeds converted spot and deposited in foreign currency. When dollars are hard to borrow, covered interest parity (CIP) deviations arise. Thus, a negative “cross-currency basis” is the U.S. dollar’s positive convenience yield.

Global financial conditions, capital flows and the exchange rate regime in emerging market economies

We examine if the sensitivity of private capital flows to global financial conditions varies across exchange rate regimes by focusing on 43 emerging market economies. We find that the flexible exchange rate regime stabilizes capital flows when the global risk aversion is low, particularly for gross liability flows; however, it fails to play such a role when the global risk aversion is high. We also show that larger covered interest parity deviations would amplify the impact of global risk aversion, which explains the failure of flexible exchange rate regimes during high global risk aversion periods.

Technology shocks and covered interest parity deviations in emerging market economies

Technology shocks and covered interest parity deviations in emerging market economies

Are Entrepreneurs Aware of Covered Interest Parity and Dollar Shortage?

Are Entrepreneurs Aware of Covered Interest Parity and Dollar Shortage?

Does the swap-covered interest parity still hold in long-term capital markets after the financial crisis? Evidence from cross-currency basis swaps

This paper analyzes the swap-covered interest parity condition by comparing US Treasury bonds with USD-denominated foreign assets replicated using cross-currency basis swaps. We find that the deviations of these yield spreads declined substantially after the financial crisis, suggesting that the swap-covered interest parity still holds. To reconcile our paradoxical findings with the previous literature that insists upon the failure of covered interest parity, we empirically confirm that the regulatory costs of cross-currency basis swaps are cancelled out by the costs of swaps spread under swap-covered interest parity.

Central bank swap arrangements in the COVID-19 crisis

Facing acute strains in the offshore dollar funding markets during the COVID-19 crisis, the Federal Reserve (Fed) provided US dollar liquidity to the global economy by reactivating or enhancing swap arrangements with other central banks and establishing a new repo facility for financial institutions and monetary authorities (FIMA). This paper assesses motivations for the Fed liquidity lines, and the effects and spillovers of US dollar auctions by central banks using these lines. We find that the access to the Fed liquidity arrangements was driven by the recipient economies’ close financial and trade ties with the US. Access to dollar liquidity also reflected global trade exposure. We find that announcements of expansion of Fed liquidity facilities or of auctions using these facilities led to appreciation of partner currencies against the US dollar and reduced these currencies’ deviations from covered interest parity (CIP). Dollar auctions by major central banks (BoE, ECB, BoJ and SNB) had spillovers: they led to temporary appreciation of other currencies against the US dollar, reduced CIP deviations, and persistently reduced sovereign bond yields of other economies. However, dollar auctions done by non-major central banks with access to Fed facilities did not have a meaningful impact on key domestic financial variables. The impact of major central bank auctions does not differ by the economies’ financial or trade links with the US or their balance sheet currency exposure, i.e. the major central bank auctions benefitted even the more vulnerable economies.

Central Bank Swap Lines: Evidence on the Effects of the Lender of Last Resort

Abstract Theory predicts that central-bank lending programs put ceilings on private domestic lending rates, reduce ex post financing risk, and encourage ex ante investment. This article shows that with global banks and integrated financial markets, but domestic central banks, then lending of last resort can be achieved using swap lines. Through them, a source central bank provides source-currency credit to recipient-country banks using the recipient central bank as the monitor and as the bearer of the credit risk. In theory, the swap lines should put a ceiling on deviations from covered interest parity, lower average ex post bank borrowing costs, and increase ex ante inflows from recipient-country banks into privately issued assets denominated in the source-country’s currency. Empirically, these three predictions are tested using variation in the terms of the swap line over time, variation in the central banks that have access to the swap line, variation in the days of the week in which the swap line is open, variation in the exposure of different securities to foreign investment, and variation in banks’ exposure to dollar funding risk. The evidence suggests that the international lender of last resort is very effective.

Currency Mispricing and Dealer Balance Sheets

ABSTRACTWe find dealer‐level evidence that recent regulation on the leverage ratio requirement causes deviations from covered interest parity. Our analysis uses a unique data set of currency derivatives with disclosed counterparty identities together with exogenous variation introduced by the U.K. leverage ratio framework. Dealers who are affected by the regulatory shock charge an additional premium of about 20 basis points per annum for synthetic dollar funding relative to unaffected dealers. This finding holds even after controlling for changes in clients' demand. Also, some clients increase their trading activity with unaffected dealers with whom they already had a preexisting relationship.

Cross‐border bank flows through foreign branches and the effect of a macroprudential policy

AbstractGlobal banks play an important role in the international transmission of shocks by allocating funds across the world through their foreign affiliates. Using monthly data on individual foreign bank branches in Korea from 2004 to 2018, this paper investigates how global banks propagate shocks and examines the effect of one particular macroprudential measure that was introduced to reduce the volatility of cross‐border bank flows. I find that foreign bank branches actively adjust their borrowing from headquarters by responding to changes in interest rates and the covered interest parity deviations. An important underlying heterogeneity is revealed: branches with high shares of loans in their balance sheets are more sensitive to interest rate changes, while branches with high bond shares respond more to the covered interest parity deviation. The macroprudential policy restricting the foreign exchange derivative positions of banks to be less than certain multiples of the long‐term capital does make the branches capitalize more by borrowing over the long term from parent banks, but the policy mostly affects the bond‐type branches and has no effect on total borrowing from the parent banks.