The Dollar, Bank Leverage, and Deviations from Covered Interest Parity

Abstract

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)

The Dynamics of Financially Constrained Arbitrage

“…In the case of long-horizon opportunities, the causal channel is different: high arbitrage-capital betas result in high collateral requirements, which in turn result in high expected returns. Our results are consistent with the relationship between expected returns or spreads on the one hand and arbitrage-capital betas on the other being increasing in the crosssection, as documented in Avdjiev et al (2016) in the context of covered interest arbitrage and Cho (2016) in the context of stock market anomalies.…”

“…Moreover, price discrepancies become larger when arbitrage capital, measured 8 See, for example, Baba andPacker (2009), Coffey, Hrung, andSarkar (2009), and Mancini Griffoli and Ranaldo (2012). 9 Other related work on CIP violations after the crisis includes Avdjiev et al (2016), Iida, Kimura, and Sudo (2016), Liao (2016), and Sushko et al (2016). 10 Consider, for example, U.S. nonfinancial firms that issue debt in euros to benefit from lower credit spreads in the euro area relative to the United States ).…”

“…The cross-sectional relationship implied by our model is consistent with recent empirical evidence. Avdjiev et al (2016) study the behavior of the CCB, which is defined in Section I.B.3 and is an arbitrage spread associated with violations of CIP. They find that currencies with a higher basis are also those for which the basis increases more when the dollar exchange rate increases.…”

Deviations from Covered Interest Rate Parity

“…In ongoing work, Avdjiev et al. () study the relationship between the strength of the dollar spot exchange rate and CIP deviations. Amador et al.…”

“…4 Building on our work, CIP deviations following the crisis have become an area of active research. In ongoing work, Avdjiev et al (2016) study the relationship between the strength of the dollar spot exchange rate and CIP deviations. Amador et al (2017) model exchange rate policy at the zero lower bound and relate it to CIP deviations.…”