Covered interest parity lost: understanding the cross-currency basis
Covered interest parity verges on a physical law in international finance. And yet it has been systematically violated since the Great Financial Crisis. Especially puzzling have been the violations since 2014, even once banks had strengthened their balance sheets and regained easy access to funding. We offer a framework to think about these violations, stressing the combination of hedging demand and tighter limits to arbitrage, which in turn reflect a tighter management of risks and bank balance sheet constraints. We find empirical support for this framework both across currencies and over time.
Authors: Claudio Borio, Robert N. McCauley, Patrick McGuire, Vladyslav Sushko
Citations: 151
Published: 2016-01-01T00:00:00.000Z
Why It Matters
Venue: BIS quarterly review. Year: 2016. Citations: 151. Abstract signal: Covered interest parity verges on a physical law in international finance. And yet it has been systematically violated since the Great Financial Crisis. Especially puzzling have been the violations since 2014, even once...
Abstract
Covered interest parity verges on a physical law in international finance. And yet it has been systematically violated since the Great Financial Crisis. Especially puzzling have been the violations since 2014, even once banks had strengthened their balance sheets and regained easy access to funding. We offer a framework to think about these violations, stressing the combination of hedging demand and tighter limits to arbitrage, which in turn reflect a tighter management of risks and bank balance sheet constraints. We find empirical support for this framework both across currencies and over time.
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