Covered Interest Parity Deviations

Asian countries have high demand for U.S. dollars and are sensitive to U.S. dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow U.S. dollars or other currencies on a hedged basis via cross-currency swap markets. These deviations can be explained by regulatory changes since the global financial crisis, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of U.S. dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while easing financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market or stable long-term investors, including a "hedging counterpart of last resort," can help stabilize financial intermediation when U.S. dollar funding markets come under stress.

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What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia?

Hong

Oeking

Kang

et al. 2020

Open Econ Rev

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Stock market and deviations from covered interest parity

Ibhagui¹

2021

Journal of International Financial Markets, Institutions and Mo

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Understanding Swiss real interest rates in a financially globalized world

Bacchetta

Benhima

Renne

2022

Swiss J Economics Statistics

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This paper proposes long-run estimates of ex ante real interest rates in Switzerland and other developed economies, and it describes their relative evolution. Our results highlight the decline in—and convergence of—global real interest rates that has unfolded over the last three decades for all maturities. While Swiss yields stand out as being particularly low and stable from a historical perspective, we find that Swiss interest rates have fallen less than in many other countries during the last decade. We then examine whether the reduction in the interest differential is related to a lower attractiveness of the Swiss franc. Focusing on the difference of Swiss minus German real government bonds yields, we find a significant increase in expected real depreciation of the Swiss franc and a somewhat lower convenience yield for Swiss bonds—the convenience yield reflecting the non-pecuniary value that investors impute to the liquidity of a given bond. In contrast, the safety premium in favor of the Swiss franc increased and therefore cannot explain the smaller decline in real interest rates in Switzerland. The last part of the paper analyzes the negative convenience yield on Swiss government bonds and its recent decline. We show that both the purchase of government bonds by foreign central banks and foreign exchange interventions by the Swiss National Bank may have contributed to this decline by reducing the relative supply of foreign versus domestic government bonds.

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Covered Interest Parity Deviations

Cited by 4 publications

References 13 publications

What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia?

What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia?

Stock market and deviations from covered interest parity

Understanding Swiss real interest rates in a financially globalized world

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