The Failure of Covered Interest Parity: FX Hedging Demand and Costly Balance Sheets

64 Pages Posted: 28 Oct 2016

See all articles by Vladyslav Sushko

Vladyslav Sushko

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

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)

Multiple version iconThere are 2 versions of this paper

Date Written: October 25, 2016

Abstract

The failure of covered interest parity (CIP), or, equivalently, the persistence of the cross currency basis, in tranquil markets has presented a puzzle. Focusing on the basis against the US dollar (USD), we show that the CIP deviations that are not due to transaction costs or bank credit risk can be explained by the demand to hedge USD forward. Fluctuations in FX hedging demand matter because committing the balance sheet to arbitrage is costly. With limits to arbitrage, CIP arbitrageurs charge a premium in the forward markets for taking the other side of FX hedgers' demand. We find that measures of FX hedging demand, combined with proxies for the risks associated with CIP arbitrage, improve the explanatory power of standard regressions.

Keywords: Covered interest parity, FX swaps, currency basis, limits to arbitrage, US dollar funding, currency hedging

JEL Classification: F31, G15, G2

Suggested Citation

Sushko, Vladyslav and Borio, Claudio E.V. and McCauley, Robert N. and McGuire, Patrick M., The Failure of Covered Interest Parity: FX Hedging Demand and Costly Balance Sheets (October 25, 2016). BIS Working Paper No. 590. Available at SSRN: https://ssrn.com/abstract=2860462

Vladyslav Sushko (Contact Author)

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

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Claudio E.V. Borio

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

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