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Covered interest parity deviations in standard monetary models

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  • Ibhagui, Oyakhilome

Abstract

Several currencies have over time exhibited persistent deviations from covered interest rate parity (CIP), resulting in non-zero cross-currency basis swap spreads. The links between these deviations and macroeconomic variables, such as those in a standard monetary model, however, have attracted less interest. In this paper, we initiate attempts to address this gap. First, we present a simple model where we allow for deviations from CIP in a standard monetary framework. With this model, we argue for the existence of levels relationships between cross-currency basis swap spreads and the macroeconomic variables. In the empirical part, we employ long-panel techniques and show that tighter cross-currency swap spreads are related to a rise in relative money supply for both European and non-European currencies and to higher relative real output for non-European currencies. We also perform error-correction analysis which reveals that the mechanism governing the adjustment to equilibrium is not the same for European and non-European currencies. However, we show that a common theme between both groups is that when there is a move away from equilibrium, it is the cross-currency basis swap spreads that adjust to ensure a return to equilibrium.

Suggested Citation

  • Ibhagui, Oyakhilome, 2020. "Covered interest parity deviations in standard monetary models," Journal of Economics and Business, Elsevier, vol. 111(C).
  • Handle: RePEc:eee:jebusi:v:111:y:2020:i:c:s0148619519301535
    DOI: 10.1016/j.jeconbus.2020.105909
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    Cited by:

    1. Ibhagui, Oyakhilome, 2021. "Real Output and Cross-Currency Basis Swap Spreads: Evidence from the Eurozone," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 75(C).

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    More about this item

    Keywords

    Cross-currency basis swap spreads; Covered interest rate parity (CIP) deviations; Standard monetary model;
    All these keywords.

    JEL classification:

    • C3 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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