Credit migration and covered interest rate parity

Abstract

This paper examines the joint determination of deviations in long-term covered interest rate parity and dierences in the credit spread of bonds of similar risk but dierent currency denomination. These two pricing anomalies are highly aligned in both the time series and the cross-section of currencies. The sum of these two pricing deviationsthe corporate basisrepresents the currency-hedged borrowing cost difference between currency regions and explains up to a third of the variation in the aggregate corporate debt issuance ow. I show that arbitrage aimed at exploiting one type of security anomaly can give rise to the other.

International Currencies and Capital Allocation

“…They apply their framework to data on Hungarian firms and study the link between their borrowing and investment decisions. Liao (2016) shows that variation in the currency-hedged cost of debt across different currencies predicts firms issuance: firms issue the most in those currencies in which borrowing is cheaper (including the cost of currency hedging). Bruno and Shin (2015a,b) study how movements in the dollar affect capital allocation and corporate investment via a balance sheet channel, and Bruno and Shin (2017) provide evidence that the recent increase in dollar borrowing by emerging market non-financial corporates is driven by these firms running a carry trade.…”

“…The wealth effect would also be affected by the extent of hedging and the residency of the counterparties with whom the bonds are hedged, as this would determine whether the exchange rate exposure remained in the country or not Liao (2016). offers useful evidence suggestive that firms often hedge, but the lack of systematic data on derivatives use precludes us from drawing too strong a conclusion.…”

Deviations from Covered Interest Rate Parity

“…() model exchange rate policy at the zero lower bound and relate it to CIP deviations. Liao () examines the implications of corporate funding cost arbitrage for CIP deviations. Rime, Schrimpf, and Syrstad () focus on the role of money market segmentation for CIP deviations.…”

The Dynamics of Financially Constrained Arbitrage

“…Other related work on CIP violations after the crisis includes Avdjiev et al. (), Iida, Kimura, and Sudo (), Liao (), and Sushko et al. ().…”

“…Conversely, bond mutual funds can invest in euro‐ or dollar‐denominated bonds but may be prevented by their mandates from trading currency forwards. Liao () links CIP violations to the hedging demand of nonfinancial firms using a segmented‐markets model.…”