Breakdown of Covered Interest Parity: Mystery or Myth?

55 Pages Posted: 22 Mar 2018 Last revised: 8 Nov 2018

See all articles by Alfred Wong

Alfred Wong

Hong Kong Monetary Authority

Jiayue Zhang

Brown University - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: March 21, 2018

Abstract

We argue that the breakdown of covered interest parity is no mystery but merely a reflection of the new trading environment in which uncollateralized and collateralized transactions have ceased to be treated as equivalent, rendering unsecured interest rates inappropriate for pricing secured transactions. We show that it is wrong to conclude from non-zero overnight indexed swap bases that the breakdown is not attributable to counterparty risk. Moreover, we document that the same phenomenon also happens to single-currency swaps and cross-currency swaps without a dollar leg, challenging the notion that the breakdown reflects a dollar funding shortage or dollar strength.

Keywords: Covered Interest Parity, FX Swap, Cross-Currency Basis Swap, Basis Spread, CIP Deviation, Libor-OIS Spread, Counterparty Credit Risk, Funding Liquidity Risk

JEL Classification: F31, G15, G2

Suggested Citation

Wong, Alfred and Zhang, Jiayue, Breakdown of Covered Interest Parity: Mystery or Myth? (March 21, 2018). Available at SSRN: https://ssrn.com/abstract=3146652 or http://dx.doi.org/10.2139/ssrn.3146652

Alfred Wong (Contact Author)

Hong Kong Monetary Authority ( email )

3 Garden Road, 30th Floor
Hong Kong
Hong Kong

Jiayue Zhang

Brown University - Department of Economics ( email )

64 Waterman Street
Providence, RI 02912
United States

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