Quantities and Covered-Interest Parity

Abstract

Studies of intermediated arbitrage argue that bank balance sheets are an important consideration, yet little evidence exists on banks' positioning in this context. Using confidential supervisory data (covering $25 trillion in daily notional exposures) we examine banks' positions in connection with covered-interest parity (CIP) deviations. Exploiting cross-sectional variation in CIP deviations that have largely challenged existing theories, we document three novel forces that drive bases: 1) foreign safe asset scarcity, 2) market power and segmentation of banks specializing in different markets, and 3) concentration of demand. Our findings shed empirical light on the interplay of frictions influencing banks' provision of dollar funding.

Keywords: F3, F31, F65, G1, G13, G15, G2, G23 basis, covered-interest parity deviation, foreign exchange, safe assets

JEL Classification: F3, F31, F65, G1, G13, G15, G2, G23