2017 Series • No. 17–3
Current Policy Perspectives
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.
Key Findings
- More stringent post-crisis bank regulations increased the cost to banks of providing dollars to the FX swap market, and lowered their incentives to engage in CIP arbitrage. A key regulatory change for U.S. banks, effective on January 1, 2013, essentially acted as an adverse supply shift, particularly for banks with lower Tier 1 capital ratios. The authors estimate that banks with a 1 percentage point lower capitalization ratio reduced their FX swaps by 19 percent more than did banks with average capitalization ratios.
- The key factor behind the recent widening of the cross-currency basis is the surge in demand for assets denominated in U.S. dollars, a situation that stems from international monetary policy differences and related interest rate differentials between the United States and other countries. This demand effect, coupled with U.S. banks reducing their participation in the FX swap market, means that the supply of dollars is no longer perfectly elastic. This situation has created a higher forward premium beyond what is predicted under the CIP condition.
- The Federal Reserve's provision of dollar swap lines with other central banks has allowed foreign central banks to supply dollars directly to their counterparties. The authors find that European banks obtain more dollar liquidity from the European Central Bank when the cost of borrowing dollars in the FX swap market is high, and that subsequently the cross-currency basis between the U.S. dollar and the euro decreases.
Implications
Deficiencies in the reallocation of funds across currencies in the FX swap market can adversely affect global banks' portfolio allocations, and also impair financial stability and monetary policy transmission. The wider cross-currency basis means that foreign investors who rely heavily on the FX swap market to satisfy their demand for U.S. dollars face higher financing costs. The authors find that central bank swap lines likely relieve pressure in the FX swap market and provide an upper limit for the cross-currency basis.
The rise of the U.S. dollar against other currencies has important policy implications for the United States, as foreigners hold over 50 percent of all outstanding debt securities issued by the U.S. Treasury. As the cost of borrowing dollars has gone up, the returns on U.S. government debt have declined, accounting for the recent selloff of Treasuries and the rise in U.S. bond yields.
Abstract
We analyze the factors underlying the recent deviations from covered interest parity. We show that these deviations can be explained by tighter post-crisis bank capital regulations that made the provision of foreign exchange swaps more costly. Moreover, the recent monetary policy and related interest rate divergence between the United States and other major foreign countries has led to a surge in demand for swapping low interest rate currencies into the U.S. dollar. Given the higher bank balance sheet costs resulting from these regulatory changes, the increased demand for U.S. dollars in the swap market could not be supplied at a constant price, thereby amplifying violations of covered interest parity. Furthermore, we show that dollar swap line agreements existing between the Federal Reserve and foreign central banks mitigate pressure in the swap market. However, the current conditions that govern the provision of dollar funding through foreign central banks are not favorable enough to reduce deviations from covered interest parity to zero.