Deviations from Covered Interest Rate Parity

Abstract

We find that deviations from the covered interest rate parity (CIP) condition imply large, persistent, and systematic arbitrage opportunities in one of the largest asset markets in the world. Contrary to the common view, these deviations for major currencies are not explained away by credit risk or transaction costs. They are particularly strong for forward contracts that appear on banks' balance sheets at the end of the quarter, pointing to a causal effect of banking regulation on asset prices. The CIP deviations also appear significantly correlated with other fixed income spreads and with nominal interest rates.

Funding Value Adjustments

“…Between 2010 and 2016, on average, over major currencies, Du, Tepper, and Verdelhan () estimate a CIP basis of about −24 basis points at three months and about −27 basis points at five years. In some currencies, especially the yen, they show that the basis has been much wider.…”

“…In this section, we consider the opportunity for trades that exploit significant recent violations of CIP. Du, Tepper, and Verdelhan (2018) and Rime, Schrimpf, and Syrstad (2017) have shown that the interest rates at which some big banks borrow U.S. dollars outright in wholesale funding markets have been significantly below the rates for synthetic U.S. dollar (USD) borrowing that could be obtained via foreign exchange (FX) markets. The synthetic method is to borrow a foreign currency, euros, for example, and to exchange the euros for dollars (at spot, and back again at maturity) using FX forward or cross-currency swaps.…”

“…Consistent with this, Wang et al (2016) find that big-bang upfronts widened bid-ask spreads significantly. 2 As another example, we consider the postcrisis violations of covered interest parity (CIP) documented by Du, Tepper, and Verdelhan (2018) and Rime, Schrimpf, and Syrstad (2017). For a dealer to benefit its shareholders by arbitraging a CIP violation, our FVA calculations imply that the magnitude of the CIP basis must roughly exceed the dealer's credit spread.…”

The Dynamics of Financially Constrained Arbitrage

“…Consistent with the hedging pressure explanation, they find that a negative CCB is more likely when these institutions seek to hedge against a drop in the dollar. Du, Tepper, and Verdelhan () argue that the demand for hedging against a drop in the dollar should be high for currencies with low interest rates relative to the dollar, and find that a negative CCB is indeed more likely for those currencies. They also relate the CCB to measures of arbitrageurs' financial constraints…”

Carry trade and forward premium puzzle from the perspective of a safe‐haven currency

“…This assumption was uncontroversial before the global financial crisis (Akram, Rime, & Sarno, ) but is currently the topic of active debate. Du, Tepper, and Verdelhan () find that there have been systematic violations of the CIP since the global financial crisis. Sushko, Borio, McCauley, and McGuire () argue that this evidence is associated with a combination of financial institutions’ demand to hedge foreign currency risk in forward exchange rate markets and binding constraints from balance sheet costs.…”