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

BIS Working Papers No. 590

75 Pages Posted: 2 Feb 2017 Last revised: 15 Aug 2017

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: July 30, 2017

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 are closely associated with the demand to hedge USD forward, and the capacity of the respective banking systems to intermediate FX hedging imbalances. Fluctuations in FX hedging demand exert significant effects on the pricing of forward exchange rates because of the re-pricing of balance sheet capacity by financial institutions. In particular, banks take account of the potential losses on their FX derivatives book, which necessitates approaching CIP arbitrage as a risky exposure. As a result, the aggregate supply curve for FX hedges via currency swaps has become upward-sloping. We find that CIP no-arbitrage bounds are endogenous to the amount of FX hedging imbalances, which explains the persistence of cross-currency basis; while 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

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 (July 30, 2017). BIS Working Papers No. 590. Available at SSRN: https://ssrn.com/abstract=2910319

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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