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

BIS Working Papers No. 590

67 Pages Posted: 2 Feb 2017 Last revised: 8 Oct 2018

Claudio E. V. Borio

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

Mobeen Iqbal

Imperial College Business School

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

Multiple version iconThere are 2 versions of this paper

Date Written: October 4, 2018

Abstract

The failure of covered interest parity (CIP), or, equivalently, the persistence of cross-currency basis, in tranquil markets has posed a puzzle in the literature. By analysing the term structure of CIP deviations, we formally establish that imbalances in the demand and supply for FX hedges exert first order effects on the level of CIP deviations. Fluctuations in FX hedging demand move forward exchange rates out of line with CIP because, in aggregate, financial institutions behave as if they charge a premium for provisioning for risks associated with exposures to FX derivatives needed to supply FX hedges. Hence, we also find that the elasticity of CIP deviations to changes in FX hedging demand depends on the interaction of proxies for market and counterparty risks. We separate these level effects from the second-order factors associated with dislocations in respective money markets that cause transient episodes of inversion in the slope of the basis term structure.

Keywords: Covered interest parity, FX swaps, currency basis, limits to arbitrage, US dollar funding, currency hedging, preferred habitat investors, term structure

JEL Classification: F31, G15, G2

Suggested Citation

Borio, Claudio E.V. and Iqbal, Mobeen and McCauley, Robert N. and McGuire, Patrick M. and Sushko, Vladyslav, The Failure of Covered Interest Parity: FX Hedging Demand and Costly Balance Sheets (October 4, 2018). BIS Working Papers No. 590. Available at SSRN: https://ssrn.com/abstract=2910319 or http://dx.doi.org/10.2139/ssrn.2910319

Claudio E.V. Borio

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

CH-4002 Basel, Basel-Stadt
Switzerland

Mobeen Iqbal

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

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 (Contact Author)

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

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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