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

  • Naohiko Baba
  • Ilhyock Shim

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.

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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 344.

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Length: 36 pages
Date of creation: Apr 2011
Date of revision:
Handle: RePEc:bis:biswps:344
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  1. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," NBER Working Papers 14473, National Bureau of Economic Research, Inc.
  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. James McAndrews & Asani Sarkar & Zhenyu Wang, 2008. "The effect of the Term Auction Facility on the London Inter-Bank Offered Rate," Staff Reports 335, Federal Reserve Bank of New York.
  4. 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.
  5. Joseph Gagnon & Matthew Raskin & Julie Remache & Brian 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.
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