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Covered interest parity lost: understanding the cross-currency basis

Author

Listed:
  • Claudio Borio
  • Robert Neil McCauley
  • Patrick McGuire
  • Vladyslav Sushko

Abstract

Covered interest parity verges on a physical law in international finance. And yet it has been systematically violated since the Great Financial Crisis. Especially puzzling have been the violations since 2014, even once banks had strengthened their balance sheets and regained easy access to funding. We offer a framework to think about these violations, stressing the combination of hedging demand and tighter limits to arbitrage, which in turn reflect a tighter management of risks and bank balance sheet constraints. We find empirical support for this framework both across currencies and over time.

Suggested Citation

  • Claudio Borio & Robert Neil McCauley & Patrick McGuire & Vladyslav Sushko, 2016. "Covered interest parity lost: understanding the cross-currency basis," BIS Quarterly Review, Bank for International Settlements, September.
  • Handle: RePEc:bis:bisqtr:1609e
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    References listed on IDEAS

    as
    1. Anthony Rush & Dena Sadeghian & Michelle Wright, 2013. "Foreign Currency Exposure and Hedging in Australia," RBA Bulletin, Reserve Bank of Australia, pages 49-58, December.
    2. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
    3. Baba, Naohiko & Packer, Frank, 2009. "From turmoil to crisis: Dislocations in the FX swap market before and after the failure of Lehman Brothers," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1350-1374, December.
    4. Naohiko Baba & Frank Packer & Teppei Nagano, 2008. "The spillover of money market turbulence to FX swap and cross-currency swap markets," BIS Quarterly Review, Bank for International Settlements, March.
    5. Bräuning, Falk & Ivashina, Victoria, 2016. "Monetary policy and global banking," Working Papers 17-5, Federal Reserve Bank of Boston.
    6. Ingo Fender & Patrick McGuire, 2010. "Bank structure, funding risk and the transmission of shocks across countries: concepts and measurement," BIS Quarterly Review, Bank for International Settlements, September.
    7. Richard M. Levich, 2012. "FX Counterparty Risk and Trading Activity in Currency Forward and Futures Markets," NBER Working Papers 18256, National Bureau of Economic Research, Inc.
    8. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking," BIS Quarterly Review, Bank for International Settlements, March.
    9. Levich, Richard M., 2012. "FX counterparty risk and trading activity in currency forward and futures markets," Review of Financial Economics, Elsevier, vol. 21(3), pages 102-110.
    10. Shin, Hyun Song, 2010. "Risk and Liquidity," OUP Catalogue, Oxford University Press, number 9780199546367.
    11. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking and the international policy response," BIS Working Papers 291, Bank for International Settlements.
    12. Nicola Cetorelli & Linda S Goldberg, 2011. "Global Banks and International Shock Transmission: Evidence from the Crisis," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 59(1), pages 41-76, April.
    13. Robert N McCauley & Patrick McGuire, 2014. "Non-US banks' claims on the Federal Reserve," BIS Quarterly Review, Bank for International Settlements, March.
    Full references (including those not matched with items on IDEAS)

    Citations

    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Rewriting the textbook: covered interest parity
      by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2016-10-17 17:50:11

    Citations

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    Cited by:

    1. Lawrence L Kreicher & Robert Neil McCauley & Philip Wooldridge, 2017. "The bond benchmark continues to tip to swaps," BIS Quarterly Review, Bank for International Settlements, March.
    2. Saleem Bahaj & Ricardo Reis, 2018. "Central Bank Swap Lines," Discussion Papers 1816, Centre for Macroeconomics (CFM).
    3. Chernov, Mikhail & Creal, Drew, 2018. "Multihorizon Currency Returns and Purchasing Power Parity," CEPR Discussion Papers 12893, C.E.P.R. Discussion Papers.
    4. Robert N. McCauley & Agustín S. Bénétrix & Patrick M. McGuire & Goetz von Peter, 2017. "Financial deglobalisation in banking?," Trinity Economics Papers tep1717, Trinity College Dublin, Department of Economics.
    5. Simone Auer, 2017. "A Financial Conditions Index for the CEE economies," Temi di discussione (Economic working papers) 1145, Bank of Italy, Economic Research and International Relations Area.
    6. Dagfinn Rime & Andreas Schrimpf & Olav Syrstad, 2017. "Segmented money markets and covered interest parity arbitrage," BIS Working Papers 651, Bank for International Settlements.
    7. Takahiro Hattori, 2017. "Does swap-covered interest parity hold in long-term capital markets after the financial crisis?," Discussion papers ron293, Policy Research Institute, Ministry of Finance Japan.
    8. Gustavo Adler & Carolina Osorio Buitron, 2017. "Tipping the Scale? The Workings of Monetary Policy through Trade," IMF Working Papers 17/142, International Monetary Fund.
    9. Saleem Bahaj & Ricardo Reis, 2018. "Central Bank Swap Lines," CESifo Working Paper Series 7124, CESifo Group Munich.
    10. Patrick Augustin & Mikhail Chernov & Dongho Song, 2018. "Sovereign Credit Risk and Exchange Rates: Evidence from CDS Quanto Spreads," NBER Working Papers 24506, National Bureau of Economic Research, Inc.
    11. repec:bis:bisbpc:96-08 is not listed on IDEAS
    12. Stijn Claessens & M Ayhan Kose, 2017. "Asset prices and macroeconomic outcomes: a survey," BIS Working Papers 676, Bank for International Settlements.
    13. repec:bis:bisbps:95 is not listed on IDEAS
    14. Michael Moore & Andreas Schrimpf & Vladyslav Sushko, 2016. "Downsized FX markets: causes and implications," BIS Quarterly Review, Bank for International Settlements, December.
    15. Matthieu Bussiere & Menzie D. Chinn & Laurent Ferrara & Jonas Heipertz, 2018. "The New Fama Puzzle," NBER Working Papers 24342, National Bureau of Economic Research, Inc.
    16. repec:bis:bisqtr:1709e is not listed on IDEAS
    17. Ricardo J. Caballero & Alp Simsek, 2016. "A Model of Fickle Capital Flows and Retrenchment," NBER Working Papers 22751, National Bureau of Economic Research, Inc.
    18. Stefan Avdjiev & Agnė Subelytė & Előd Takáts, 2016. "The ECB's QE and euro cross-border bank lending," BIS Quarterly Review, Bank for International Settlements, September.
    19. repec:kap:asiaeu:v:15:y:2017:i:4:d:10.1007_s10308-017-0492-3 is not listed on IDEAS
    20. Bank for International Settlements, 2017. "Foreign exchange liquidity in the Americas," BIS Papers, Bank for International Settlements, number 90.
    21. repec:eee:empfin:v:42:y:2017:i:c:p:199-211 is not listed on IDEAS
    22. repec:eee:pacfin:v:44:y:2017:i:c:p:47-63 is not listed on IDEAS

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