Breakdown of Covered Interest Parity: Mystery or Myth?

Abstract

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The Failure of Covered Interest Parity: FX Hedging Demand and Costly Balance Sheets

“…It also assumes that the investment leg must use safe assets, such as short-term government bills or central bank deposits (which offer low or negative yields). Wong, Ng, and Leung (2017) and Wong and Zhang (2017) argue that the post-GFC pricing of currency forwards and swaps can be reconciled with money-market rates that are stripped of premia from counterparty risk.…”

FX spot and swap market liquidity spillovers

“…In addition, we contribute to academic literature on CIP violations in a non-crisis time, beginning with Du, Tepper, and Verdelhan (2018), who show that neither credit risk nor transactions costs can explain the anomaly in the period of relative calm. Some studies have focused on the demand-side for FX hedges (Bräuning and Ivashina, 2017;Iida, Kimura, and Sudo, 2018;Borio, Iqbal, McCauley, McGuire, and Sushko, 2016;Abbassi and Brauning, 2018), others on liquidity and risk premia asymmetries in the respective money markets (Rime, Schrimpf, and Syrstad, 2017;Wong and Zhang, 2017). In turn, Avdjiev, Du, Koch, and Shin (2019) relate CIP deviations to the shadow price of bank leverage that fluctuates with US dollar exchange rate.…”

The Term Structure of Covered Interest Rate Parity Violations

“…Coffey, Hrung, and Sarkar (2009) and Bahaj and Reis (2018) support such views by documenting that U.S. swap lines to foreign central banks are effective in reducing CIP deviations. Other explanations relate to an increase in bank counterparty risk associated with the crisis (Baba and Packer, 2009;Csavas, 2016;Levich, 2012;Skinner and Mason, 2011;Tuckman and Porfirio, 2003;Wong, Leung, and Ng, 2016;Wong and Zhang, 2018). Coffey, Hrung, andSarkar (2009) andFong, Valente, andFung (2010) provide evidence in support of both credit and liquidity risk as drivers of CIP deviations.…”