We find that deviations from the covered interest rate parity condition (CIP) imply large, persistent, and systematic arbitrage opportunities in one of the largest asset markets in the world. Contrary to the common view, these deviations for major currencies are not explained away by credit risk or transaction costs. They are particularly strong for forward contracts that appear on the banks' balance sheets at the end of the quarter, pointing to a causal effect of banking regulation on asset prices. The CIP deviations also appear significantly correlated with other fixed-income spreads and with nominal interest rates.
We document a triangular relationship in that a stronger dollar goes hand in hand with larger deviations from covered interest parity (CIP) and contractions of cross-border bank lending in dollars. We argue that underpinning the triangle is the role of the dollar as a key barometer of risk-taking capacity in global capital markets. (JEL F23, F31, G15, G21)
We find that deviations from the covered interest rate parity (CIP) condition imply large, persistent, and systematic arbitrage opportunities in one of the largest asset markets in the world. Contrary to the common view, these deviations for major currencies are not explained away by credit risk or transaction costs. They are particularly strong for forward contracts that appear on banks' balance sheets at the end of the quarter, pointing to a causal effect of banking regulation on asset prices. The CIP deviations also appear significantly correlated with other fixed income spreads and with nominal interest rates.
We introduce a new measure of emerging market sovereign credit risk: the local currency credit spread, defined as the spread of local currency bonds over the synthetic local currency risk-free rate constructed using cross-currency swaps. We find that local currency credit spreads are positive and sizable. Compared with credit spreads on foreign currencydenominated debt, local currency credit spreads have lower means, lower crosscountry correlations, and are less sensitive to global risk factors. We discuss several major sources of credit spread differentials, including selective default, capital controls, covariance between currency and credit risk, and various financial market frictions.
We introduce a new measure of emerging market sovereign credit risk: the local currency credit spread, defined as the spread of local currency bonds over the synthetic local currency risk-free rate constructed using cross-currency swaps. We find that local currency credit spreads are positive and sizable. Compared with credit spreads on foreign-currency-denominated debt, local currency credit spreads have lower means, lower cross-country correlations, and lower sensitivity to global risk factors. We discuss several major sources of credit spread differentials, including positively correlated credit and currency risk, selective default, capital controls, and various financial market frictions. WHEN A SOVEREIGN borrows in its own currency, the spread it pays over the U.S. Treasury risk-free benchmark might contain two major types of risk: currency risk and credit risk. We introduce a new sovereign risk measure, the local currency (LC) credit spread, to measure the credit risk component of LCdenominated debt. We find that the LC credit spread is positive and sizable for emerging market sovereigns, despite their ability to print their own currency to repay the debt. Furthermore, we document significant differences between the LC credit spread and the conventional measure of emerging market sovereign * Wenxin Du is with the Federal Reserve Board and Jesse Schreger is with Princeton University and Harvard Business School. We are especially grateful to
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