Interconnected Deviations from Covered Interest Parity

Abstract

We investigate the dynamic interconnectedness among the major world cross-currency basis swap spreads during tranquil and turbulent times. We examine whether movements in the bases are merely anecdotal or provide evidence of contagion, the most central basis for spillover propagation, and implications for market participants. The result shows a high degree of interconnectedness among the bases in crisis periods with mark-to-market losses for existing exposures and large arbitrage opportunities for investors seeking new positions. We find evidence that spillovers in the bases propagate from the Euro, the Swiss franc, and the Danish krone to other bases.

Keywords: Covered Interest Parity, Cross-currency Basis, Currency Swaps, Dollar Funding, Financial Crisis, Interconnectedness, VAR Model.

JEL Classification: C11, C32, F31, G01, G15