The shifting drivers of covered interest parity deviations
Covered interest rate parity has been a central principle in international finance, but important departures have persisted since the Global Crisis. This column argues that several macro-financial factors – reflecting risk appetite, monetary policies, and financial regulations – correlate over time with the evolution of covered interest parity deviations. The failure of covered interest rate parity has several policy implications, ranging from the domestic and international transmission of monetary policies to inefficient market allocations.
The principle of covered interest parity (CIP), set out by Keynes (1923) during the floating exchange rate period after WWI, is a fundamental building block of international finance. Absent counterparty risk, CIP is a pure no-arbitrage relationship that equates the premium of a currency’s forward over its spot exchange rate (both rates expressed as the price of foreign currency) to its nominal interest-rate advantage over foreign currency. Under CIP, for example, for those comparing two ways effectively to borrow US dollars, the US dollar interest rate equals the total cost of borrowing euros, buying dollars in the spot foreign exchange market, and selling those dollars forward for euros to repay the original loan. CIP expresses the potential for arbitrage to align borrowing costs and investment returns in integrated money and foreign exchange markets.
For several decades until the Global Crisis, CIP appeared to hold quite closely – even as a broad macroeconomic description applying to weekly or even daily data. The relationship seems to have broken down since the onset of the global crisis, however, as Figure 1 illustrates in the case of the three-month investment horizon. That CIP deviations emerged in the turbulence of the global crisis itself is not surprising in view of counterparty fears during that period and is not unprecedented either. What has been more puzzling is the continuation of CIP deviations – at times larger, at times smaller – well after the Global Crisis, and even for virtually riskless transactions (Du et al. 2018).
Figure 1 Three-month Libor basis, 2002-2020
Note: Ten-day averages of three-month dollar CIP deviations based on IBOR interest rates for G10 currencies (updating Figure 1 in Du et al. 2018 to 25 September 2020).
Even before the Global Crisis, CIP seems to have rarely held exactly. Detailed tick-frequency studies such as Akram et al. (2008) were able to detect small and transient – but economically meaningful – departures from CIP. Nonetheless, CIP still provided an excellent guide to the relationship among forward and spot exchange rates and interest rates at the macro level. As Akram et al. (2008) put it, “the lack of predictability of arbitrage and the fast speed at which arbitrage opportunities are exploited and eliminated imply that a typical researcher in international macro-finance using data at the daily or lower frequency can safely assume that CIP holds”. This claim is no longer valid.
Macro-financial drivers of covered interest parity deviations
A growing recent literature tries to rationalise the recent CIP deviations. Different authors have stressed a range of often complementary potential drivers. In Cerutti et al. (2020), we organise the several proposed drivers of CIP deviations into the three buckets of (1) factors reflecting financial regulations, (2) factors reflecting risk appetite and perceptions, and (3) factors reflecting monetary policies.1
In the absence of financial frictions, an arbitrageur could take advantage of CIP deviations to earn riskless profits. Regulatory changes since the Global Crisis have affected CIP deviations by amplifying or dampening the influence of risk and policy factors. Du et al. (2018) characterise the dynamics of CIP deviations near regulatory reporting dates as ‘smoking gun’ evidence on the role of regulatory constraints on potential arbitrageurs’ balance sheets. These constraints, when they become more binding, magnify the normal effects of the drivers. In Cerutti et al. (2020), we offer additional related evidence that the recently introduced surcharge on globally systemically important banks (G-SIBs) provides an additional impetus for CIP deviations near the fourth-quarter regulatory evaluation period for G-SIB balance sheets.
We find that factors connected with risk appetite and perceptions have been important drivers of CIP, being associated with financial tightening and higher risk aversion. Key measures of FX market liquidity – for example, the forward bid-ask spread – and intermediaries’ risk-taking capacity – for example, He et al.’s (2017) squared intermediary leverage ratio – are strongly correlated with deviations from CIP. Broad US dollar strength also correlates strongly with CIP deviations, as highlighted by Avdjiev et al. (2019), but the correlation seems mainly to capture a common factor reflecting safe-haven currencies’ co-movements, as we show in our paper.
Among monetary factors related to the evolution of CIP deviations, we identify US and foreign IBOR rates, the international term premium differential, and the residual from projecting the broad US dollar index on the safe haven common factor, as the dollar’s non-safe haven movement may broadly capture the effect of monetary policy through the ‘risk-taking channel’ (Bruno and Shin 2015). A low interest rate environment and unconventional monetary policies are among the drivers of global capital flows post-crisis, and thus have the potential to affect deviations from CIP through portfolio rebalancing, hedged dollar borrowing, and international financial flows.
In general, we conclude that while risk-related factors have more explanatory power for CIP deviations than factors related to monetary policy during 2010-2018 period taken as a whole, both sets of factors appear approximately equally influential over the 2014-2018 subsample. In a similar vein, Lilley et al. (2020) find that intermediary returns – unimportant for explaining broad US dollar movements before the global crisis – become important afterward, but with declining influence over time.
Implications for policy of covered interest parity deviations
As we highlighted in our paper, the failure of CIP is important for at least three reasons.
First, it may be evidence of financial market frictions or unintended policy consequences that potentially entail inefficient resource allocation. For example, for non-US investors in dollar-denominated securities, such as pension funds, and for insurance companies in Europe and Japan, post-Global Crisis deviations from CIP may add to the costs of hedging against exchange rate movements. Fully hedging one’s entire dollar portfolio may become less justifiable when CIP deviations widen to increase the cost of hedging, strengthening the motive to seek better yields by unwinding FX derivatives, substituting into riskier securities, or scaling back dollar investments altogether.
Second, CIP deviations may elucidate asset pricing in a world where financial intermediary constraints are stochastic and potentially binding (Du et al. 2019) – to some degree they capture financial stresses that simultaneously affect a range of markets.
Third, and related to the global financial cycle, it becomes less plausible that small economies can exercise monetary policy independently of the Federal Reserve’s interest rate choice because forward and spot exchange rates will adjust automatically to insulate the domestic monetary setting from the Fed’s (Bernanke 2017). Unless CIP holds closely, domestic actors may be able to borrow or lend synthetically in domestic currency at a rate that is different from the domestic central bank rate, but dependent on Fed policy.
Akram, Q F, D Rime and L Sarno (2008), “Arbitrage in the foreign exchange market: Turning on the microscope”, Journal of International Economics 76(2): 237–253.
Avdjiev, S, W Du, C Koch and H S Shin (2019), “The dollar, bank leverage, and deviations from Covered Interest Parity”, American Economic Review: Insights 1(2): 193–208.
Bernanke, B S (2017), “Federal Reserve policy in an international context”, IMF Economic Review 65: 1–32.
Bruno, V G and H S Shin (2015), “Capital flows and the risk-taking channel of monetary policy”, Journal of Monetary Economics 71: 119–132.
1 Some variables may reflect multiple factors, of course. The US dollar’s exchange rate is a notable example. It reflects both risk-appetite factors – like safe-haven movements – and other factors that affect the exchange rate, notably monetary policy