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Arbitraging Covered Interest Rate Parity Deviations and Bank Lending

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  • Lorena Keller

Abstract

I propose and test a new channel through which covered interest rate parity (CIP) deviations can affect bank lending in emerging economies. I argue that when CIP deviations exist, banks attempt to arbitrage them. To do so, banks must borrow in a particular currency. When this currency is scarce, bank lending in the currency required to arbitrage decreases, while they use this currency in their arbitrage activities. I test this channel by exploiting differences in the abilities of Peruvian banks to arbitrage CIP deviations. I find evidence that supports the proposed channel.

Suggested Citation

  • Lorena Keller, 2024. "Arbitraging Covered Interest Rate Parity Deviations and Bank Lending," American Economic Review, American Economic Association, vol. 114(9), pages 2633-2667, September.
    • Handle: RePEc:aea:aecrev:v:114:y:2024:i:9:p:2633-67
    DOI: 10.1257/aer.20230425
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    References listed on IDEAS

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    1. Varela, Liliana & Alfaro, Laura & Calani, Mauricio, 2021. "Granular Corporate Hedging Under Dominant Currency," CEPR Discussion Papers 16232, C.E.P.R. Discussion Papers.
    2. Mark P. Taylor & Lucio Sarno, 2001. "Official Intervention in the Foreign Exchange Market: Is It Effective and, If So, How Does It Work?," Journal of Economic Literature, American Economic Association, vol. 39(3), pages 839-868, September.
    3. Gutierrez, Bryan & Ivashina, Victoria & Salomao, Juliana, 2023. "Why is dollar debt Cheaper? Evidence from Peru," Journal of Financial Economics, Elsevier, vol. 148(3), pages 245-272.
    4. Humala, Alberto, 2019. "Corporate earnings sensitivity to FX volatility and currency exposure: evidence from Peru," Working Papers 2019-021, Banco Central de Reserva del Perú.
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    Cited by:

    1. Philippe Bacchetta & J. Scott Davis & Eric van Wincoop, 2025. "Dollar Funding Fragility and non-US Global Banks," Swiss Finance Institute Research Paper Series 25-65, Swiss Finance Institute.
    2. Miguel Acosta-Henao & María Alejandra Amado & Montserrat Martí & David Pérez-Reyna, 2025. "Heterogeneous UIPDs across Firms: Spillovers from U.S. Monetary Policy Shocks," Working Papers 2530, Banco de España.
    3. Aldunate, Felipe & Da, Zhi & Larrain, Borja & Sialm, Clemens, 2025. "Pension fund flows, exchange rates, and covered interest rate parity," Journal of Financial Economics, Elsevier, vol. 170(C).
    4. repec:osf:socarx:v8zdk_v1 is not listed on IDEAS
    5. Fabiani, Josefina & Neanidis, Kyriakos C., 2025. "The bank-lending channel of macroprudential policy: Evidence from cross-border bank flows," Journal of International Economics, Elsevier, vol. 157(C).

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    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G01 - Financial Economics - - General - - - Financial Crises
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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