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

Abstract

BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org).

Segmented Money Markets and Covered Interest Parity Arbitrage

“…They argue that the pricing anomaly stems from global demand and supply imbalances arising from differences in countries' net international positions and that deviations are too large to be explained by transaction costs alone, giving rise to significant arbitrage opportunities. Sushko, Borio, McCauley, and McGuire (2016) further corroborate the role of imbalances in the FX swap market. Drawing on measures of dollar funding gaps of different banking systems, they highlight the role of FX hedging demand as an important driver.…”

“…However, as emphasized in Sushko, Borio, McCauley, and McGuire (2016), some counterparty risk is inherent in the FX swap transaction itself despite collateralization. However, so-called two-way Credit Support Annex (CSA) agreements that are standard in FX swaps reduce the capital cost significantly and hence these costs are not very relevant for the maturities studied in this paper.…”

The Dynamics of Financially Constrained Arbitrage

“…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 ).…”

Deviations from Covered Interest Rate Parity

“…Sushko et al. () link the estimated dollar hedging demand (quantities) for major currencies to variation in CIP deviations (prices).…”

“…Rime, Schrimpf, and Syrstad (2016) focus on the role of money market segmentation for CIP deviations. Sushko et al (2016) link the estimated dollar hedging demand (quantities) for major currencies to variation in CIP deviations (prices). determination in the presence of moral hazard.…”