Interpreting Deviations from Covered Interest Parity during the Financial Market Turmoil of 2007-08

22 Pages Posted: 27 Jan 2009  

Naohiko Baba

Bank of Japan - Financial Markets Department

Frank Packer

Bank for International Settlements (BIS)

Date Written: December 1, 2008

Abstract

This paper investigates the spillover effects of money market turbulence in 2007-08 on the short-term covered interest parity (CIP) condition between the US dollar and the euro through the foreign exchange (FX) swap market. Sharp and persistent deviations from the CIP condition observed during the turmoil are found to be significantly associated with differences in the counterparty risk between European and US financial institutions. Furthermore, evidence is found that dollar term funding auctions by the ECB, supported by dollar swap lines with the Federal Reserve, have stabilized the FX swap market by lowering the volatility of deviations from CIP.

Keywords: FX swap, covered interest parity, financial market turmoil, counterparty risk, dollar swap lines, dollar term auction facility

JEL Classification: F31, G15

Suggested Citation

Baba, Naohiko and Packer , Frank, Interpreting Deviations from Covered Interest Parity during the Financial Market Turmoil of 2007-08 (December 1, 2008). BIS Working Paper No. 267. Available at SSRN: https://ssrn.com/abstract=1334125 or http://dx.doi.org/10.2139/ssrn.1334125

Naohiko Baba

Bank of Japan - Financial Markets Department ( email )

2-1-1, Hongoku-cho
Nihonbashi
Chuo-ku, Tokyo, 103
Japan

Frank Packer (Contact Author)

Bank for International Settlements (BIS) ( email )

CH-4002 Basel, Basel-Stadt
Switzerland
4161 280 8449 (Phone)

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