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Risk-adjusted Covered Interest Parity: Theory and Evidence


  • Alfred Wong

    (Hong Kong Monetary Authority)

  • David Leung

    (Hong Kong Monetary Authority)

  • Calvin Ng

    (Hong Kong Monetary Authority)


We extend the theory of covered interest parity (CIP), aligning the different risks involved in uncollateralized money market transactions and collateralized foreign exchange (FX) swap transactions, which underscore CIP deviations in times of elevated uncertainty. We postulate that the swap dealer behaves as if he tries to filter out the counterparty risk embedded in money market rates in pricing FX swaps. Our results suggest that he does so not only during turbulent times but also under normal market conditions. The extended theory also uncovers a simple way to disentangle counterparty and liquidity risk premiums embedded in money market rates.

Suggested Citation

  • Alfred Wong & David Leung & Calvin Ng, 2016. "Risk-adjusted Covered Interest Parity: Theory and Evidence," Working Papers 162016, Hong Kong Institute for Monetary Research.
  • Handle: RePEc:hkm:wpaper:162016

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    Covered interest parity; CIP deviation; forward rate; exchange rate; Libor-OIS spread; counterparty credit risk; funding liquidity risk; FX swap;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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