Uncovering Covered Interest Parity: The Role of Bank Regulation and Monetary Policy
Covered interest parity (CIP) is a concept holding that the interest rates paid on two similar assets that only differ in their denominated currencies should, after controlling for any foreign exchange rate risk, be the same. Fulfilling this condition depends on the idea that international capital mobility is largely frictionless. More specifically, the theory underpinning CIP predicts that converting the amount borrowed in a foreign currency using the foreign exchange (FX) spot market, while simultaneously hedging the resulting exchange rate risk using a foreign exchange forward contract, should result in a cross-currency basis equal to zero. (Such a simultaneous spot purchase and forward sale of foreign currency is called an FX swap, a contract in which investors essentially borrow in one currency and lend in another currency.) Because the U.S. dollar is the dominant global currency used in international trade and finance, trades against the dollar account for about 90 percent of the activity that occurs in the FX swap market. The ten largest global banking institutions account for two-thirds of the trades in the FX swap market, with nonfinancial corporations and other investors also using the FX swap market to hedge foreign currency risk or engage in arbitrage activity.
Historically, the CIP relationship was so stable across countries that it came to be regarded as one of the few binding laws in economics. Prior to the 2007–2008 financial crisis, the cross-currency basis was close to zero for all pairs, but after the crisis began, large violations of CIP were present, especially with respect to the U.S. dollar. When the European sovereign debt crisis arose in early 2010, the cross-currency basis also widened, but then flattened out by late 2012. While credit risk and liquidity risk have subsequently remained low, since mid-2014 large and persistent violations of CIP have been observed, resulting in substantial increases in the cost of borrowing U.S. dollars in the FX swap market. This paper analyzes the driving factors behind these most recent deviations in the CIP condition.