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Risk-adjusted Covered Interest Parity: Theory and Evidence

Author

Listed:
  • Alfred Wong

    (Hong Kong Monetary Authority)

  • David Leung

    (Hong Kong Monetary Authority)

  • Calvin Ng

    (Hong Kong Monetary Authority)

Abstract

We extend the theory of covered interest parity (CIP), aligning the different risks involved in uncollateralized money market transactions and collateralized foreign exchange (FX) swap transactions, which underscore CIP deviations in times of elevated uncertainty. We postulate that the swap dealer behaves as if he tries to filter out the counterparty risk embedded in money market rates in pricing FX swaps. Our results suggest that he does so not only during turbulent times but also under normal market conditions. The extended theory also uncovers a simple way to disentangle counterparty and liquidity risk premiums embedded in money market rates.

Suggested Citation

  • Alfred Wong & David Leung & Calvin Ng, 2016. "Risk-adjusted Covered Interest Parity: Theory and Evidence," Working Papers 162016, Hong Kong Institute for Monetary Research.
    • Handle: RePEc:hkm:wpaper:162016
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    References listed on IDEAS

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    Cited by:

    1. Dagfinn Rime & Andreas Schrimpf & Olav Syrstad, 2022. "Covered Interest Parity Arbitrage," Review of Financial Studies, Society for Financial Studies, vol. 35(11), pages 5185-5227.
    2. Vladyslav Sushko & Claudio Borio & Robert Neil McCauley & Patrick McGuire, 2016. "The failure of covered interest parity: FX hedging demand and costly balance sheets," BIS Working Papers 590, Bank for International Settlements.
    3. Patrick Augustin & Mikhail Chernov & Lukas Schmid & Dongho Song, 2020. "The Term Structure of Covered Interest Rate Parity Violations," NBER Working Papers 27231, National Bureau of Economic Research, Inc.
    4. Alexis Stenfors, 2019. "The Covered Interest Parity Puzzle and the Evolution of the Japan Premium," Journal of Economic Issues, Taylor & Francis Journals, vol. 53(2), pages 417-424, April.
    5. Dagfinn Rime & Andreas Schrimpf & Olav Syrstad, 2017. "Segmented money markets and covered interest parity arbitrage," Working Paper 2017/15, Norges Bank.
    6. Ibhagui, Oyakhilome, 2021. "Stock market and deviations from covered interest parity," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 74(C).
    7. Oyakhilome Ibhagui, 2021. "Inflation differential as a driver of cross-currency basis swap spreads," The European Journal of Finance, Taylor & Francis Journals, vol. 27(6), pages 510-536, April.
    8. William A. Allen & Gabriele Galati & Richhild Moessner & William Nelson, 2017. "Central bank swap lines and CIP deviations," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 22(4), pages 394-402, October.
    9. Olav Syrstad, 2020. "Covered Interest Parity in long-dated securities," Working Paper 2020/11, Norges Bank.
    10. Dr. Daniel Kohler & Dr. Benjamin Müller, 2019. "Covered interest rate parity, relative funding liquidity and cross-currency repos," Working Papers 2019-05, Swiss National Bank.
    11. Chernov, Mikhail & Augustin, Patrick & Schmid, Lukas & Song, Dongho, 2020. "The term structure of CIP violations," CEPR Discussion Papers 14774, C.E.P.R. Discussion Papers.
    12. Anella Munro, 2016. "Bond premia, monetary policy and exchange rate dynamics," Reserve Bank of New Zealand Discussion Paper Series DP2016/11, Reserve Bank of New Zealand.

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    More about this item

    Keywords

    Covered interest parity; CIP deviation; forward rate; exchange rate; Libor-OIS spread; counterparty credit risk; funding liquidity risk; FX swap;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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