BIS Working Papers No. 590
73 Pages Posted: 2 Feb 2017 Last revised: 9 May 2017
Date Written: October 30, 2016
The failure of covered interest parity (CIP), or, equivalently, the persistence of the cross currency basis, in tranquil markets has presented a puzzle, as there has been mounting evidence that post-crisis CIP deviations cannot be explained by bank credit and liquidity factors. Focusing on the basis against the US dollar (USD), we show that the CIP deviations are closely associated with the demand to hedge USD forward. Fluctuations in FX hedging demand matter because committing the balance sheet to FX derivatives in order to arbitrage away FX hedging imbalances is costly. CIP arbitrageurs charge a premium in the forward markets in proportion to their marginal balance sheet costs of taking the other side of FX hedgers' demand. We find that CIP no-arbitrage bounds are endogenous to the amount of FX hedging imbalances, which explains the persistence of cross-currency basis. Additional short-term fluctuations of cross-currency basis largely reflect changes in funding and market liquidity conditions.
Keywords: Covered interest parity, FX swaps, currency basis, limits to arbitrage, US dollar
JEL Classification: F31, G15, G2
Suggested Citation: Suggested Citation
Sushko, Vladyslav and Borio, Claudio E. V. and McCauley, Robert N. and McGuire, Patrick, The Failure of Covered Interest Parity: FX Hedging Demand and Costly Balance Sheets (October 30, 2016). BIS Working Papers No. 590. Available at SSRN: https://ssrn.com/abstract=2910319