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From CIP-Deviations to a Market for Risk Premia: A Dynamic Investigation of Cross-Currency Basis Swaps

Author

Listed:
  • Ioannis Chatziantoniou

    (Portsmouth Business School)

  • David Gabauer

    (Webster Vienna Private University, Johannes Kepler University)

  • Alexis Stenfors

    (Portsmouth Business School)

Abstract

The persistent deviations from the covered interest rate parity (CIP) since 2007 indicate that specific frictions continue to exist, which prevent them from being arbitraged away. In this study, we study the cross-currency basis swap market and put forward the argument that the risk premium expressed via the CIP-deviation constitutes a unique market that determines its own equilibrium price after receiving feedback from various sources, including contagion within the market itself. We investigate contagion using a TVP-VAR framework of analysis that measures the extent of connectedness across the bases on all G10 currencies against the US dollar between 2007 and 2018. Our main findings indicate that connectedness is event-dependent. Furthermore, we provide evidence that net-transmitting bases are typically associated with safe haven currencies (e.g. CHF) and banking sectors with significant overseas operations (e.g. EUR and JPY). On a pairwise level, results confirm that during tranquil times in international financial markets, connectedness subdues and even reaches negligible levels - particularly for stable banking systems (e.g. CAD) or without significant US dollar funding gaps (e.g. AUD).

Suggested Citation

  • Ioannis Chatziantoniou & David Gabauer & Alexis Stenfors, 2019. "From CIP-Deviations to a Market for Risk Premia: A Dynamic Investigation of Cross-Currency Basis Swaps," Working Papers in Economics & Finance 2019-05, University of Portsmouth, Portsmouth Business School, Economics and Finance Subject Group.
  • Handle: RePEc:pbs:ecofin:2019-05
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    More about this item

    Keywords

    CIP-Deviations; Cross-Currency Basis Swaps; Dynamic Connectedness; Spillover Analysis; TVP-VAR;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • F3 - International Economics - - International Finance
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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