BIS Working Papers No 590
70 Pages Posted: 2 Feb 2017
Date Written: January 30, 2017
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 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 in proportion to their balance sheet exposure. 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
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 (January 30, 2017). BIS Working Papers No 590. Available at SSRN: https://ssrn.com/abstract=2910319