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Dislocations in the won-dollar swap markets during the crisis of 2007-09

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  • Naohiko Baba
  • Ilhyock Shim

Abstract

Foreign exchange (FX) derivatives markets in the Korean won are comparatively thin and vulnerable to impaired functioning. During the crisis, Korea faced dislocations in its FX swap and cross-currency swap markets, so severe that covered interest parity (CIP) between the Korean won and the US dollar was seriously violated. Using a variation of the EGARCH model, we find that global market uncertainty - as proxied by VIX, the volatility index - was the main factor explaining the movement of deviations from CIP in the three-month FX swap market during the crisis period. The credit risk of Korean banks - as proxied by their credit default swap spread - was also a significant factor explaining deviations from CIP in the three-year cross-currency swap market before the crisis, while the credit risk of US banks was significant during the crisis period. The Bank of Korea's provision of funds using its own foreign reserves was not effective in reducing deviations from CIP, but the Bank of Korea's loans of the US dollar proceeds of swaps with the US Federal Reserve were effective. This is because the loans funded by swaps with the US Federal Reserve effectively added to Korea's foreign reserves and enhanced market confidence.

Suggested Citation

  • Naohiko Baba & Ilhyock Shim, 2011. "Dislocations in the won-dollar swap markets during the crisis of 2007-09," BIS Working Papers 344, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:344
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    References listed on IDEAS

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    1. Niall Coffey & Warren B. Hrung & Asani Sarkar, 2009. "Capital constraints, counterparty risk, and deviations from covered interest rate parity," Staff Reports 393, Federal Reserve Bank of New York.
    2. Brenda González-Hermosillo & Heiko Hesse, 2011. "Global Market Conditions and Systemic Risk," Journal of Emerging Market Finance, Institute for Financial Management and Research, vol. 10(2), pages 227-252, August.
    3. repec:eee:jbfina:v:83:y:2017:i:c:p:135-152 is not listed on IDEAS
    4. Joseph E. Gagnon & Matthew Raskin & Julie Remache & Brian P. Sack, 2011. "Large-scale asset purchases by the Federal Reserve: did they work?," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 41-59.
    5. McAndrews, James & Sarkar, Asani & Wang, Zhenyu, 2017. "The effect of the term auction facility on the London interbank offered rate," Journal of Banking & Finance, Elsevier, vol. 83(C), pages 135-152.
    6. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters,in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:

    1. Pornpinun Chantapacdepong & Ilhyock Shim, 2014. "Correlations across Asia-Pacific bond markets and the impact of capital flow measures," BIS Working Papers 472, Bank for International Settlements.
    2. Kazumasa Iwata & Shinji Takenaka, 2012. "Central bank balance sheet expansion: Japan's experience," BIS Papers chapters,in: Bank for International Settlements (ed.), Are central bank balance sheets in Asia too large?, volume 66, pages 132-159 Bank for International Settlements.
    3. Andrew Filardo, 2011. "The Impact of the International Financial Crisis on Asia and the Pacific: Highlighting Monetary Policy Challenges from a Negative Asset Price Bubble Perspective," BIS Working Papers 356, Bank for International Settlements.
    4. Pierluigi Morelli & Giovanni Pittaluga & Elena Seghezza, 2015. "The role of the Federal Reserve as an international lender of last resort during the 2007–2008 financial crisis," International Economics and Economic Policy, Springer, vol. 12(1), pages 93-106, March.

    More about this item

    Keywords

    FX swap; cross-currency swap; regime switching; EGARCH model; foreign reserves;

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