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
Date Written: October 4, 2018
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: Suggested Citation