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

Abstract

Significant deviations from covered interest parity were observed during the financial crisis of [2007][2008][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.

Revisiting Covered Interest Parity in the European Union: the DCCA Approach

“…Indeed, Taylor (1989) presents market turbulence as a possible cause of those deviations. Furthermore, studies such as those by Packer (2009a, 2009b) and Hui, Genberg, and Chung (2011) also point to deviations linked with market turbulence. These authors advance three main conclusions about CIP deviations: (i) differences in the counterparty risk between European and US financial institutions; (ii) there was some behavior by both monetary institutions to stabilize swap markets (after identifying problems of liquidity in these markets); (iii) less liquidity in markets, during the crisis.…”

Funding liquidity constraints and the forward premium anomaly in a DSGE model

“…These liquidity spirals deviate the exchange rate from its fundamental value and prevent high-interest-rate currencies from depreciating, creating a scenario in which UIP does not hold. Hui, Genberg, and Chung (2011) and Mancini Griffoli and Ranaldo (2012) also empirically document the importance of a funding liquidity constraint in explaining the arbitrage deviations.…”

Liquidity risk contagion in the interbank market

“…The term LIBOR-OIS spread has the role of evaluating the health of banks, for it mirrors the risk linked with lending to other banks. In times of financial distress, the LIBOR-OIS spread is a fitting indicator of risk premiums as a result of credit and funding liquidity risk (McAndrews et al, 2008;Hui et al, 2011). Alan Greenspan advocates that the LIBOR-OIS spread is an indicator of alarm for bank insolvency, and inflated spread levels reveal struggles in the banking industry.…”

“…The authors prove that monetary policy changes are mirrored in the widening of spreads, and increased volatility is the result of noisy market behaviour. Hui et al (2011) claim that the spillover of the crisis from the US to the European market was moderate between the period mid-2007 to mid-2008, and funding liquidity risk played a major part in the development of the global financial crisis. However, during the crisis of 2007-08, the authors find considerable deviations from covered interest rate parity and argue that the widening of the LIBOR-OIS spread mainly reflects funding liquidity risk in the interbank market, and subsequently it can be used to measure funding liquidity conditions.…”

“…Gorton and Metrick (2012) trace the spillover of the credit crunch by investigating the causes of repo haircuts to find that fluctuations in the interbank LIBOR-OIS spread were correlated with increases in the non-subprime securitised assets and associated derivatives spreads. Other analyses argue that the LIBOR-OIS spread encompasses credit and liquidity risk premia (McAndrews et al, 2008;Michaud and Upper, 2008;Sengupta and Tam, 2008;Hui et al, 2011). Schwarz (2014) finds that during the first half of the credit crisis of 2007-08, more than 60% of widening of both the one and three-month Euro LIBOR-OIS spreads and the Eurozone sovereign debt spreads can be accredited to market liquidity effects.…”