What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia

36 Pages Posted: 27 Aug 2019

See all articles by Gee Hee Hong

Gee Hee Hong

International Monetary Fund (IMF)

Anne Oeking

International Monetary Fund (IMF)

Kenneth Kang

International Monetary Fund (IMF)

Changyong Rhee

International Monetary Fund (IMF) - Asia and Pacific Department

Date Written: August 2019

Abstract

Asian countries have high demand for U.S. dollars and are sensitive to U.S. dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow U.S. dollars or other currencies on a hedged basis via cross-currency swap markets. These deviations can be explained by regulatory changes since the global financial crisis, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of U.S. dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while easing financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market or stable long-term investors, including a 'hedging counterpart of last resort,' can help stabilize financial intermediation when U.S. dollar funding markets come under stress.

Keywords: Financial crises, Central banks, Financial institutions, Macroprudential policies and financial stability, Exchange risk, Covered interest parity, limits to arbitrage, U.S.dollar funding, FX swaps., IIP, GFC, interbank, CCBS, CIP

JEL Classification: F31, G15, G2, E01, G21, E52, F16, E22

Suggested Citation

Hong, Gee Hee and Oeking, Anne and Kang, Kenneth and Rhee, Changyong, What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia (August 2019). IMF Working Paper No. 19/169, Available at SSRN: https://ssrn.com/abstract=3442884

Gee Hee Hong (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Anne Oeking

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Kenneth Kang

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Changyong Rhee

International Monetary Fund (IMF) - Asia and Pacific Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
42
Abstract Views
331
PlumX Metrics