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Capital Constraints, Counterparty Risk, and Deviations from Covered Interest Rate Parity


Niall Coffey


Federal Reserve Banks - Federal Reserve Bank of New York

Warren B. Hrung


Federal Reserve Bank of New York

Asani Sarkar


Federal Reserve Bank of New York

October 29, 2009

FRB of New York Staff Report No. 393

Abstract:     
We provide robust evidence of deviations from the Covered Interest Parity (CIP) relation since the onset of the crisis in August 2007. The CIP deviations exist with respect to different dollar interest rates and exchange rate pairs of the dollar vis-à-vis other currencies. The results show that our proxies for margin conditions and cost of capital are significant determinants of the basis. Following the bankruptcy of Lehman Brothers, uncertainty about counterparty risk became a significant determinant of CIP deviations. The supply of dollars by the Federal Reserve to foreign central banks via reciprocal currency arrangements (swap lines) reduced CIP deviations. In particular, the announcement on October 13 2008 that the swap lines would become unlimited reduced CIP deviations substantially. These results indicate a breakdown of arbitrage transactions in the international capital markets during the crisis partly due to lack of funding and partly due to heightened counterparty credit risk. Central bank interventions helped to reduce the funding liquidity risk of global institutions.

Number of Pages in PDF File: 48

Keywords: covered interest parity, funding constraints, counterparty credit risk, central bank currence swap lines, financial crisis, foreign exchange

JEL Classification: G10, G14, G15, G18

working papers series


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Date posted: September 15, 2009 ; Last revised: June 8, 2010

Suggested Citation

Coffey, Niall and Hrung, Warren B. and Sarkar, Asani, Capital Constraints, Counterparty Risk, and Deviations from Covered Interest Rate Parity (October 29, 2009). FRB of New York Staff Report No. 393. Available at SSRN: http://ssrn.com/abstract=1473377 or http://dx.doi.org/10.2139/ssrn.1473377

Contact Information

Niall Coffey
Federal Reserve Banks - Federal Reserve Bank of New York ( email )
33 Liberty Street
New York, NY 10045
United States
Warren B. Hrung
Federal Reserve Bank of New York ( email )
33 Liberty Street
New York, NY 10045
United States
Asani Sarkar (Contact Author)
Federal Reserve Bank of New York ( email )
Research Department
33 Liberty Street
New York, NY 10045
United States
212-720-8943 (Phone)
212-720-1582 (Fax)
HOME PAGE: http://www.newyorkfed.org/research/economists/sarkar/pub.html
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