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

48 Pages Posted: 15 Sep 2009 Last revised: 8 Jun 2010

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

Date Written: October 29, 2009

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.

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

JEL Classification: G10, G14, G15, G18

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: https://ssrn.com/abstract=1473377 or http://dx.doi.org/10.2139/ssrn.1473377

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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