Funding Liquidity Risk and Deviations from Interest-Rate Parity During the Financial Crisis of 2007-2009
International Journal of Finance and Economics, Vol. 16, pp. 307-323, 2011
17 Pages Posted: 31 Jul 2009 Last revised: 20 Sep 2011
Date Written: July 20, 2011
Significant deviations from covered interest parity were observed during the financial crisis of 2007-2009. This paper finds that before the failure of Lehman Brothers the market-wide funding liquidity risk was the main determinant of these deviations in terms of the premiums on swap-implied US dollar interest rates for the euro, British pound, Hong Kong dollar, Japanese yen, Singapore dollar and Swiss Franc. This evidence suggests that the deviations can be explained by the existence and nature of liquidity constraints. After the Lehman default, both counterparty risk and funding liquidity risk in the European economies were the significant determinants of the positive deviations, while the tightened liquidity condition in the US dollar was the main driving factor of the negative deviations in the Hong Kong, Japan and Singapore markets. Federal Reserve Swap lines with other central banks that eased the liquidity pressure reduced the positive deviations in the European economies.
Keywords: sub-prime crisis, funding liquidity, covered interest parity, FX swaps
JEL Classification: F31, F32, F33
Suggested Citation: Suggested Citation