Breakdown of Covered Interest Parity: Mystery or Myth?
55 Pages Posted: 22 Mar 2018 Last revised: 8 Nov 2018
Date Written: March 21, 2018
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: Suggested Citation