Covered Interest Parity Research Articles

The Dynamics of Arbitrage: Evidence from the Forward Markets

Covered interest parity (CIP) is the theoretical relationship that explains the price difference between spot and forward exchange rates in terms of the interest rate differential between the home and the foreign currency. CIP arbitrage maintains the parity pricing between a host of financial products traded in currency, interest rate and derivatives markets with different denominations and maturities. However, market frictions cause the parity price to oscillate within a trading band, which is found to vary in size over time. We investigate the drivers behind the arbitrage dynamics using a three regime Bivariate Threshold AutoRegressive (BTAR) model where the bivariate pair is the implied and actual forward exchange rates and the threshold value is the difference between the two. When studying different maturities of the US dollar-Japanese yen relation, one state represents times when US dollar borrowers have a comparative advantage, one state represents times when Japanese yen borrowers have an advantage, and a third state represents white noise around the theoretical rate. The arbitrage profit is asymmetric and varies with maturity as well as state: the largest profit arises when US dollar borrowers have the advantage, while the largest profit variance occurs when yen borrowers have the advantage. Finally, we offer a more precise explanation of asset volatility and the manner it affects the CIP relation: intraday US interest rate (LIBOR) volatility and not exchange rate volatility appears to be the main driver of the trading band apparent in the three regimes. This suggests that CIP should continue during periods of exchange rate turbulence but will likely come to a standstill during periods of interest rate turbulence. These findings support the importance of maintaining liquidity in interest rate and credit markets as additional mechanisms to adjust exchange rate disequilibrium during times of crisis.

Margin and Funding Liquidity: An Empirical Analysis on the Covered Interest Parity in Korea

During the global financial turmoil in 2007-2008, deviation from the covered interest parity (CIP) between the Korean won and US dollar through the foreign exchange swap has escalated in its magnitude beyond 1,000bp in November 2008, and it still persists around 100bp level. In this paper, we examine a newly developed margin based asset pricing model using Kalman filter approach and show that the escalation of the CIP deviation is found to be significantly related to the global dollar funding illiquidity and country-specific funding conditions. Furthermore, we find evidence that the poor funding conditions (or higher margins) are driven by the general money market illiquidity and may lead to higher funding illiquidity, which suggests the reinforcing effects of the liquidity spiral. We also show that the supply of dollar liquidity and improved funding conditions help alleviate the deviations from the parity, however the persistent anomaly is found to be related to the high level of exchange rate volatility.

Liquidity Contagion: A Look at Emerging Markets

Emerging economies have passed an important stress test during the period 2008-09 andare now the key drivers for global growth of the world economy. Financial markets are todayso inter connected that they are fragile to contagion. The issue of financial contagion washistorically concerning Emerging Markets (EM). These latter attract foreign investors andmassive investments funds in - and out - flows on very short horizons can be a source of contagion effects between markets. The analysis of the sovereign debt markets and particularlyrelated CDS markets is of interest since it is at the very center of a new phenomenon: banksare not any more the main source of systemic risk but sovereign economies are. As foreigninvestors represent the most of the volume traded, capital flows in these markets should also impact FX market. Their analysis is thus also central to this study. Indeed, the mainrisk for an asset manager is to get stuck with unwanted sovereign debt due to a dry up ofmarket liquidity. The main contribution of this paper is the analysis of contagion looking atcommon markets liquidity problems to detect funding liquidity problems. We use the CreditDefault Swap bond spread basis and the deviations from the Covered Interest Parity as liquidity measures respectively for sovereign debt and FX markets. Moreover, we distinguishinterdependence and pure contagion using a state-space model with a time - varying volatilityspecification and we apply it to both returns and liquidity indicators.

Covered Interest Parity Deviations Between India And The US

Prior studies have tested Covered Interest Parity (CIP) between India and the United States and found substantial deviations. The main objective of the current study is to econometrically model and explain deviations from CIP. Further, the study contributes to the literature by proposing an approach to testing CIP after allowing for country risk. A preliminary analysis suggests that there are two types of shocks that impact the CIP deviation, also referred to as the Covered Interest Differential (CID): permanent shocks and temporary shocks. The permanent shocks may be interpreted as reflecting a change in the country risk premium and the temporary shocks as reflecting transient effects and disequilibrium. The paper uses a bivariate Vector Autoregression (VAR) approach to model the joint dynamics of the CID and the forward premium, and applies the methodology of Blanchard and Quah (1989) to separate the impact of the two types of shocks. Impulse-Response analysis shows that a one standard deviation permanent shock has an immediate, substantial impact on the CID. However, forecast error variance decomposition reveals that less than 30% of the variability in the CID is caused by such permanent shocks. Further, permanent shocks account for less than 5% of the forecast error variance of the forward premium, which suggests that covered interest arbitrage activity has limited influence on the forward premium. Temporary shocks appear to be related to transient volatility in the forward premium, and such shocks initially affect both the forward premium and the CID to approximately the same extent. The manner in which the CID responds to a temporary shock suggests considerable impediments to arbitrage. However, the fact that the CID recovers at a slightly faster rate than the forward premium, especially in the initial periods, suggests that capital restrictions are not completely binding.

Modeling Covered Interest Parity Deviations - A Structural VAR Approach

The paper develops a simple model to explain Covered Interest Parity (CIP) deviations. The model allows for a time-varying country risk premium and is used to motivate a Structural Vector Auto-Regression (SVAR) approach to study the joint dynamics of the Covered Interest Differential (CID) and the Forward Premium (FP). Three independent, structural shocks are postulated – a country risk premium shock, an inflation rate differential shock and a forward market shock. Long run restrictions are imposed to enable identification of the parameters relating the structural shocks to the reduced form shocks. The main contributions are as follows. (1) The paper develops a methodology to relate movements in the VAR endogenous variables to a larger number of structural shocks than the number of endogenous variables. (2) The paper proposes this SVAR methodology as a way to test CIP on a risk-adjusted basis. The identifying restrictions are motivated by the theoretical model mentioned earlier. The SVAR methodology allows one to relate movements in CID and FP to underlying structural shocks and provides information regarding the speed of market response to these shocks. In the process, the methodology sheds light on why CIP does not hold. (3) The paper makes an empirical contribution by applying this methodology to study financial integration between Indian and US markets at the short end of the curve.

Pippenger's CIP-based solution to the forward-bias puzzle: A rejoinder

Pippenger (2011a) proposed a solution to the longstanding forward-bias puzzle that attracted several comments, to which he has recently replied ( Pippenger, 2011b). In this rejoinder it is argued that the points Pippenger raises in defence of his solution do not effectively rebut the concerns originally raised. In addition, his model is found to generate puzzling regression results when applied to real-world data. It is shown that these results arise because his model's coefficients represent (potentially biased) estimates of the covered interest parity equation's coefficients.

Fundamentalist Exchange Rate Trading Performances

The question on the predictive power of different exchange rate equilibrium models is one of the oldest and most intriguing in international finance and assets trading. On one side there is evidence - starting from Meese and Rogoff (1983) to Cheung, Chinn and Pascual (2005) - about the poor performance of fundamental models such as purchasing power parity (PPP) or covered interest parity (CIP). On the other side, practitioner asset managers often trade with a very simple rule - carry trade (CT) - assuming that currencies with high interest rates will appreciate against those with low interest rates, which goes exactly the opposite way than what predicted by CIP. Many studies, for example Gyntelberg and Remolona (2007) or Galati, Heath and McGuire P., Heath A., Galati G. (2007) revealed a good performance of CT models in recent years, but some authors underlined that returns exhibit a strong (left) asymmetry in their distribution - Gagnon and Chaboud (2007) - and are negative in periods of high volatility, such as market crises - Brunnermeier, Nagel and Pedersen (2009), Cairns, Ho and McCauley (2007). In the light of these new findings and relying on the evidence - by De Zwart, Markwat, Swinkels and van Dijk (2009), Jorda and Taylor (2009) - that fundamentals have an informative power we reconsider and compare the main fundamental relations on exchange rates by the trading performance obtained going long the under-valued currency and short the over-valued one. Our sample is made of G-10 currencies plus 8 currencies of minor/emerging countries with deliverable forward contracts. We tested the performance of simple trading rules based on mispricing signals from three different exchange rate fundamental relations: PPP, UIP in terms of real interest rates, GDP growth differentials through the so called Taylor Rule (TR). Models are estimated with monthly data and trading performances evaluated as annualised monthly return rates. Trading results are analysed in terms of return, volatility and Sharp ratio over the entire sample and portofolios made of selections of currencies. Henceforth the comparison between fundamentalist trading strategies takes into account differences across the sample, potentially linked to the different nature of the three equilibrium relations employed. Results are supportive for Purchasing Power Parity and for the Taylor Rule.

Regional Liquidity Risk and Covered Interest Parity During the Global Financial Crisis: Evidence from Tokyo, London, and New York

During the global financial crisis, there were substantial deviations from the covered interest parity (CIP) condition. In particular, during the post Lehman period, the US dollar interest rate became very low on the forward market, as compared to the rate suggested by the CIP condition. However, the deviations from the CIP condition varied not only across currencies but also across markets. After presenting a simple model, the following analysis examines the CIP condition between the Japanese Yen and the US dollar and explores how it was violated in Tokyo, London, and New York markets. We show that the US dollar interest rate temporarily became lowest in the New York market soon after the Lehman shock but was lowest in the Tokyo market during the rest of the post Lehman turmoil. This implies that liquidity shortage of the US dollar during the rest of the post Lehman turmoil was most serious in Tokyo time when the New York market is closed. The regression results suggest that both credit and liquidity risks explain the difference across the markets. In particular, coordinated central bank liquidity provision was useful in reducing US dollar liquidity risk. However, we observe varieties of asymmetric effects across the markets.

On the (in)feasibility of covered interest parity as a solution to the forward bias puzzle

This paper examines Pippenger's (2011) proposed solution to the forward bias puzzle, which is based on the covered interest parity (CIP) condition. It is argued that the CIP-based approach does not solve this well known and long-standing puzzle in international finance in a meaningful way. Moreover, it is shown that empirical results from such an approach follow mechanically from the identity-like nature of the theory of covered interest parity, which, aside from small deviations due to transaction costs, is assumed to hold in all periods (as if it were an identity). We show that rather than leading to new insights, the simple reconfiguration of CIP to solve for the time t + 1 spot exchange rate leads to tautological expressions that, when estimated, might appear to successfully explain the forward bias, but in actuality are trivial. Results from simple simulation exercises further illustrate the inconclusiveness of the proposed solution method.

A comment on: “The solution to the forward-bias puzzle”

Pippenger (2011) recently proposed a solution to the longstanding forward-bias puzzle. He argues that the puzzling estimates obtained using the standard equation for the efficient markets hypothesis are due to omitted variable bias. He identifies the missing variables as the future change in the forward exchange rate and the future interest differential. When these are added to the standard equation, he finds a one-to-one relationship between the future change in the spot rate and the forward premium. However, we argue that his equation can only test covered interest parity and offers no insight into the forward-bias puzzle.

Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity

Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity

The solution to the forward-bias puzzle

Although it has taken some 30 years to find, the solution to the forward-bias puzzle is straightforward. The standard test equation that produces the puzzle is missing two variables that covered interest parity implies should be included. For my data, those two missing variables explain the downward bias in the forward-bias puzzle. Covered interest parity also solves another closely related puzzle. The variance for changes in exchange rates is 100–200 times larger than the variance in forward premiums.

Bank Competition and International Financial Integration: Evidence Using a New Index

This paper finds a strong empirical link between domestic banking sector competitiveness and de facto international integration. De-facto international integration is measured through a new index of financial integration, which measures, for deviations from covered interest parity, the size of no-arbitrage bands and the speed of arbitrage outside the no-arbitrage band.

Why Issue Bonds Offshore?

This paper asks why Asia-Pacific residents issue debt in offshore markets and considers the implications for domestic debt markets. We use unit record data for bond issuance by non-government residents of Australia, Hong Kong, Korea, Japan and Singapore to link the decision to issue offshore to potential benefits. The results suggest that residents of smaller markets issue bonds offshore to arbitrage price differentials; to access foreign investors; and to issue larger, lower-rated or longer-maturity bonds. These bond characteristics tend to be correlated with offshore bond market size. The results support the notions that (i) deviations from covered interest parity are actively arbitraged by residents of minor currency areas, as well as by internationally active borrowers, as established in the literature; and (ii) issuers benefit from the liquidity and diversification of larger complete offshore markets. Against the potential benefits to borrowers, we consider the risks for both borrowers and the domestic market, and lessons from the ongoing financial crisis such as the benefits of funding diversification.

Funding liquidity risk and deviations from interest-rate parity during the financial crisis of 2007-2009

Significant deviations from covered interest parity were observed during the financial crisis of 2007–2009. This paper finds that before the failure of Lehman Brothers market-wide funding liquidity risk was the main determinant of these deviations measured by swap-implied US dollar (USD) interest rates for the euro, British pound, Hong Kong dollar, Japanese yen, Singapore dollar and Swiss Franc relative to US Libor rates. This evidence suggests that the deviations can be explained by the existence and nature of liquidity constraints. After the Lehman default, both counterparty risk and funding liquidity risk in the European economies were the significant determinants of the positive deviations found for these currencies, while the tightened liquidity condition in the USD was the main driving factor of the negative deviations in the Hong Kong, Japan and Singapore markets. The negative deviations reflect the fact that these markets became alternative dollar funding sources as borrowing in the European economies became more difficult. Federal Reserve Swap lines with other central banks that eased the liquidity pressure reduced the positive deviations in the European economies. Copyright © 2010 John Wiley & Sons, Ltd.

The forward premium puzzle in the interwar period and deviations from covered interest parity

We revisit the forward premium puzzle in the interwar period and find that, as the deviation from covered interest rate parity increases, the coefficient on the forward premium in the standard Fama regression tends towards zero.

Foreign-currency bonds: currency choice and the role of uncovered and covered interest parity

Using count-data techniques, this article studies the determinants of currency choice in the issuance of foreign-currency-denominated bonds. In particular, we investigate whether bond issuers choose their issuance currency in order to exploit the borrowing-cost savings associated with deviations from uncovered and covered interest parity. Our findings show that the choice of issuance currency is sensitive to deviations from uncovered interest parity but insensitive, in general, to deviations from covered interest parity. Furthermore, the influence of deviations from uncovered interest parity is stronger for financial issuers than for nonfinancial issuers. In as much as the issuance of foreign-currency-denominated bonds affects the relative international standing of world currencies, one implication of these findings is that monetary policy, through its influence on nominal interest rates, has a greater impact on the internationalization of currencies than has been previously accounted for.

Adopt the euro? The GME approach

The objective of this paper is to evaluate the degree of financial integration achieved in the European Union based on covered interest parity and using Generalized Maximum Entropy. EU countries are divided into two groups according to their current situation with respect to the adoption of the euro. Financial integration before the adoption of the euro is analyzed for the countries that adopted the euro in 1999. Similarly, current financial integration is evaluated for non-euro EU countries. Besides the importance of comparing the situation of the non-euro EU countries with the situation of the euro EU countries previous to the euro adoption, which may be useful to evaluate an eventual decision of the non-euro members to adopt the euro, it is interesting to analyze the performance of Generalized Maximum Entropy. Generalized Maximum Entropy has the ability to estimate the parameters of a regression model without imposing any constrains on the probability distribution of errors and it is robust even when we have ill-posed problems. Overall our results suggest that the degree of financial integration on non-euro countries is lower than the degree of financial integration that existed among euro adopting countries before the adoption of the euro.

Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity

Arbitrage ensures that covered interest parity holds. The condition is central to price foreign exchange forwards and interbank lending rates, and reflects the efficient functioning of markets. Normally, deviations from arbitrage, if any, last seconds and reach a few basis points. After the Lehman bankruptcy, instead, arbitrage profits were large, persisted for months and involved borrowing in dollars. The first goal of this paper is to measure precisely such deviations from arbitrage. By using high frequency prices from novel datasets , we are able to exactly replicate two major arbitrage strategies: “secured” and “unsecured” arbitrage. Specifically, arbitrage can be undertaken by borrowing and lending funds on secured terms, as would a hedge fund, or on unsecured terms, as would a bank's proprietary trading desk (prop desk). The distinction draws on that made in Brunnermeier and Pedersen (2009). Both arbitrage strategies yield very similar and consistent results. The second goal of the paper is to investigate why arbitrage broke down. Empirical analysis suggests that insufficient funding liquidity in dollars kept traders from arbitraging away excess profits. Risk factors, instead, are mostly insignificant. Liquidity factors involve intermediaries cutting back loans to arbitrageurs in order to shrink their balance sheet, and hoarding liquidity to cover their own funding strains. In addition, it seems that arbitrageurs themselves had insufficient pledge-able capital to fund their arbitrage trades. This paper contributes to the literature on slow moving capital. It shows how capital constraints turn into enduring arbitrage opportunities. For policymakers, it shows that certain unconventional monetary policy measures (in particular central bank swap lines) were effective at providing the necessary funding liquidity in dollars and re-establishing arbitrage across money markets.

Covered interest arbitrage profits: The role of liquidity and credit risk

We study the profitability of Covered Interest Parity (CIP) arbitrage violations and their relationship with market liquidity and credit risk using a novel and unique dataset of tick-by-tick firm quotes for all financial instruments involved in the arbitrage strategy. The empirical analysis shows that positive CIP arbitrage deviations include a compensation for liquidity and credit risk. Once these risk premia are taken into account, small arbitrage profits only accrue to traders who are able to negotiate low trading costs. The results are robust to stale pricing and the nonsynchronous trading occurring in the markets involved in the arbitrage strategy.