Dislocations in the Won-Dollar Swap Markets During the Crisis of 2007-09

36 Pages Posted: 8 Jun 2011 Last revised: 17 Apr 2020

See all articles by Ilhyock Shim

Ilhyock Shim

Bank for International Settlements (BIS)

Naohiko Baba

Bank of Japan - Financial Markets Department

Date Written: April 1, 2011

Abstract

Foreign exchange (FX) derivatives markets in the Korean won are comparatively thin and vulnerable to impaired functioning. During the crisis, Korea faced dislocations in its FX swap and cross-currency swap markets, so severe that covered interest parity (CIP) between the Korean won and the US dollar was seriously violated. Using a variation of the EGARCH model, we find that global market uncertainty - as proxied by VIX, the volatility index - was the main factor explaining the movement of deviations from CIP in the three-month FX swap market during the crisis period. The credit risk of Korean banks - as proxied by their credit default swap spread - was also a significant factor explaining deviations from CIP in the three-year cross-currency swap market before the crisis, while the credit risk of US banks was significant during the crisis period. The Bank of Korea's provision of funds using its own foreign reserves was not effective in reducing deviations from CIP, but the Bank of Korea's loans of the US dollar proceeds of swaps with the US Federal Reserve were effective. This is because the loans funded by swaps with the US Federal Reserve effectively added to Korea's foreign reserves and enhanced market confidence.

Keywords: FX swap, cross-currency swap, regime switching, EGARCH model, foreign reserves

JEL Classification: G12, G13, G18

Suggested Citation

Shim, Ilhyock and Baba, Naohiko, Dislocations in the Won-Dollar Swap Markets During the Crisis of 2007-09 (April 1, 2011). BIS Working Paper No. 344, Available at SSRN: https://ssrn.com/abstract=1859249 or http://dx.doi.org/10.2139/ssrn.1859249

Ilhyock Shim (Contact Author)

Bank for International Settlements (BIS) ( email )

78F, Two International Finance Centre
8 Finance Street, Central
Hong Kong, n/a n/a
Hong Kong

HOME PAGE: http://www.bis.org/author/ilhyock_shim.htm

Naohiko Baba

Bank of Japan - Financial Markets Department ( email )

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

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