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The failure of covered interest parity: FX hedging demand and costly balance sheets

Author

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

Abstract

The failure of covered interest parity (CIP), or, equivalently, the persistence of the cross currency basis, in tranquil markets has presented a puzzle. Focusing on the basis against the US dollar (USD), we show that the CIP deviations that are not due to transaction costs or bank credit risk can be explained by the demand to hedge USD forward. Fluctuations in FX hedging demand matter because committing the balance sheet to arbitrage is costly. With limits to arbitrage, CIP arbitrageurs charge a premium in the forward markets for taking the other side of FX hedgers' demand. We find that measures of FX hedging demand, combined with proxies for the risks associated with CIP arbitrage, improve the explanatory power of standard regressions.

Suggested Citation

  • Vladyslav Sushko & Claudio Borio & Robert Neil McCauley & Patrick McGuire, 2016. "The failure of covered interest parity: FX hedging demand and costly balance sheets," BIS Working Papers 590, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:590
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    References listed on IDEAS

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    5. Bräuning, Falk & Ivashina, Victoria, 2016. "Monetary policy and global banking," Working Papers 17-5, Federal Reserve Bank of Boston.
    6. Patrick McGuire & Goetz von Peter, 2012. "The Dollar Shortage in Global Banking and the International Policy Response," International Finance, Wiley Blackwell, vol. 15(2), pages 155-178, June.
    7. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
    8. Michael M Hutchison & Gurnain Kaur Pasricha & Nirvikar Singh, 2012. "Effectiveness of Capital Controls in India: Evidence from the Offshore NDF Market," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 60(3), pages 395-438, September.
    9. Shin, Hyun Song, 2010. "Risk and Liquidity," OUP Catalogue, Oxford University Press, number 9780199546367.
    10. François-Louis Michaud & Christian Upper, 2008. "What drives interbank rates? Evidence from the Libor panel," BIS Quarterly Review, Bank for International Settlements, March.
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    Citations

    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. U.S. Monetary Policy Spillovers
      by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2018-11-12 13:07:42

    Citations

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    Cited by:

    1. Stenfors, Alexis, 2018. "Bid-ask spread determination in the FX swap market: Competition, collusion or a convention?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 54(C), pages 78-97.
    2. 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.
    3. Dedola, Luca & Georgiadis, Georgios & Grab, Johannes & Mehl, Arnaud, 2018. "Does a Big Bazooka Matter? Central Bank Balance-Sheet Policies and Exchange Rates," Globalization Institute Working Papers 350, Federal Reserve Bank of Dallas.
    4. Andrea Mantovi, 2018. "The monetary dimension of arbitrage. A brief note," Working Paper series 18-27, Rimini Centre for Economic Analysis, revised Oct 2018.
    5. repec:fau:fauart:v:67:y:2017:i:3:p:199-220 is not listed on IDEAS
    6. A. Berthou & G. Horny & J-S. Mésonnier, 2018. "Dollar Funding and Firm-Level Exports," Working papers 666, Banque de France.
    7. Ibhagui, Oyakhilome, 2018. "The Monetary Model of CIP Deviations," MPRA Paper 89641, University Library of Munich, Germany.
    8. Alexis Stenfors, 2018. "The Covered Interest Parity Puzzle and the Evolution of the Japan Premium," Working Papers in Economics & Finance 2018-10, University of Portsmouth, Portsmouth Business School, Economics and Finance Subject Group.

    More about this item

    Keywords

    Covered interest parity; FX swaps; currency basis; limits to arbitrage; US dollar funding; currency hedging;

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