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Funding Liquidity Risk and Deviations from Interest-Rate Parity During the Financial Crisis of 2007-2009

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Author Info

  • Cho-Hoi Hui

    (Research Department, Hong Kong Monetary Authority)

  • Hans Genberg

    (Research Department, Hong Kong Monetary Authority)

  • Tsz-Kin Chung

    (Research Department, Hong Kong Monetary Authority)

Abstract

Significant deviations from covered interest parity were observed during the financial crisis of 2007-2009. This paper finds that before the failure of Lehman Brothers the market-wide funding liquidity risk was the main determinant of these deviations in terms of the premiums on swap-implied US dollar interest rates for the euro, British pound, Hong Kong dollar, Japanese yen, Singapore dollar and Swiss Franc. This 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, while the tightened liquidity condition in the US dollar was the main driving factor of the negative deviations in the Hong Kong, Japan and Singapore markets. Federal Reserve Swap lines with other central banks eased the liquidity pressure and reduced the positive deviations in the European economies.

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Bibliographic Info

Paper provided by Hong Kong Monetary Authority in its series Working Papers with number 0913.

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Length: 30 pages
Date of creation: Jul 2009
Date of revision:
Handle: RePEc:hkg:wpaper:0913

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Keywords: Sub-prime crisis; funding liquidity; covered interest parity; FX swaps;

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References

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  1. John B. Taylor & John C. Williams, 2008. "A Black Swan in the Money Market," NBER Working Papers 13943, National Bureau of Economic Research, Inc.
  2. Frenkel, Jacob A & Levich, Richard M, 1977. "Transaction Costs and Interest Arbitrage: Tranquil versus Turbulent Periods," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(6), pages 1209-26, December.
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  5. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 19(3), pages 418-437, July.
  6. Covrig, Vicentiu & Low, Buen Sin & Melvin, Michael, 2004. "A Yen is Not a Yen: TIBOR/LIBOR and the Determinants of the Japan Premium," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 39(01), pages 193-208, March.
  7. Melvin, Michael & Taylor, Mark P, 2009. "The Crisis in the Foreign Exchange Market," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7472, C.E.P.R. Discussion Papers.
  8. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
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Cited by:
  1. Liu, Hao-Chen & Witte, Mark David, 2013. "The microstructure of covered interest arbitrage in a market with a dominant market maker," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 24(C), pages 25-41.
  2. Rose, Andrew K & Spiegel, Mark, 2011. "Dollar Illiquidity and Central Bank Swap Arrangements During the Global Financial Crisis," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8557, C.E.P.R. Discussion Papers.
  3. Mauricio Calani & Kevin Cowan & Pablo García S., 2011. "Inflation Targeting in Financially Stable Economies: Has it Been Flexible Enough?," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Luis Felipe Céspedes & Roberto Chang & Diego Saravia (ed.), Monetary Policy under Financial Turbulence, edition 1, volume 16, chapter 1, pages 283-368 Central Bank of Chile.
  4. Dong He & Robert McCauley, 2010. "Offshore markets for the domestic currency: monetary and financial stability issues," BIS Working Papers, Bank for International Settlements 320, Bank for International Settlements.
  5. Matthew S. Yiu & Joseph K. W. Fung & Lu Jin & Wai-Yip Alex Ho, 2010. "Liquidity Crunch in Late 2008: High-Frequency Differentials between Forward-Implied Funding Costs and Money Market Rates," Working Papers, Hong Kong Institute for Monetary Research 262010, Hong Kong Institute for Monetary Research.
  6. Ka-Fai Li & Cho-Hoi Hui & Tsz-Kin Chung, 2012. "Determinants and Dynamics of Price Disparity in Onshore and Offshore Renminbi Forward Exchange Rate Markets," Working Papers, Hong Kong Institute for Monetary Research 242012, Hong Kong Institute for Monetary Research.
  7. Mark R. Stone & W. Christopher Walker & Yosuke Yasui, 2009. "From Lombard Street to Avenida Paulista," IMF Working Papers, International Monetary Fund 09/259, International Monetary Fund.
  8. Beirne, John, 2012. "The EONIA spread before and during the crisis of 2007–2009: The role of liquidity and credit risk," Journal of International Money and Finance, Elsevier, Elsevier, vol. 31(3), pages 534-551.
  9. Pennings, Steven & Ramayandi, Arief & Tang, Hsiao Chink, 2011. "The Impact of Monetary Policy on Financial Markets in Small Open Economies: More or Less Effective During the Global Financial Crisis?," Working Papers on Regional Economic Integration, Asian Development Bank 72, Asian Development Bank.
  10. Laurence Fung & Ip-wing Yu, 2009. "Dislocations in FX Swap and Money Markets in Hong Kong and Policy Actions during the Financial Crisis of 2008," Working Papers, Hong Kong Monetary Authority 0917, Hong Kong Monetary Authority.

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