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Covered Interest Parity Lost: Understanding the Cross-Currency Basis

20 Pages Posted: 5 Oct 2016  

Claudio E. V. Borio

Bank for International Settlements (BIS) - Research and Policy Analysis

Robert N. McCauley

Bank for International Settlements (BIS)

Patrick McGuire

Bank for International Settlements (BIS)

Vladyslav Sushko

Bank for International Settlements (BIS) - Monetary and Economic Department

Date Written: September 18, 2016

Abstract

Covered interest parity verges on a physical law in international finance. And yet it has been systematically violated since the Great Financial Crisis. Especially puzzling have been the violations since 2014, even once banks had strengthened their balance sheets and regained easy access to funding. We offer a framework to think about these violations, stressing the combination of hedging demand and tighter limits to arbitrage, which in turn reflect a tighter management of risks and bank balance sheet constraints. We find empirical support for this framework both across currencies and over time.

JEL Classification: F31, G15, G2

Suggested Citation

Borio, Claudio E. V. and McCauley, Robert N. and McGuire, Patrick and Sushko, Vladyslav, Covered Interest Parity Lost: Understanding the Cross-Currency Basis (September 18, 2016). BIS Quarterly Review September 2016. Available at SSRN: https://ssrn.com/abstract=2842331

Claudio E.V. Borio (Contact Author)

Bank for International Settlements (BIS) - Research and Policy Analysis ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

Robert N. McCauley

Bank for International Settlements (BIS) ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

Patrick M. McGuire

Bank for International Settlements (BIS) ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

Vladyslav Sushko

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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