Covered interest parity is an arbitrage condition that equalizes costs of direct USD funding and of synthetic USD funding through FX swaps. Deviations are called dollar cross-currency basis and have become a common occurrence since the great financial crisis. A negative dollar basis means direct funding in USD – if accessible – is cheaper than synthetic funding via swaps. An apparent structural cause of the dollar basis has been regulatory tightening, which has increased balance sheet costs of arbitrage. Moreover, research has found several short-term factors. Thus, a negative dollar basis has been linked to aggregate USD strength, rising market volatility, deteriorating FX market liquidity, monetary tightening in the U.S. relative to other countries, and a decrease of funds in the USD money market. In most of these cases, the dollar basis represents dollar funding conditions not captured by published interest rates and is a valid trading signal.

Eugenio Cerutti, Maurice Obstfeld, and Haonan Zhou (2019), “Covered Interest Parity Deviations: Macrofinancial Determinants”, IMF Working Paper, WP/19/14

This post ties in with SRSV’s summary lecture on implicit subsidies in financial markets, particularly the section on foreign exchange.

The below are excerpts from the paper. Emphasis and cursive text have been added.

What is covered interest parity (CIP)?

“Absent counterparty risk, CIP is a pure arbitrage relationship that links the premium of a currency’s forward over its spot exchange rate to its nominal interest-rate advantage over foreign currency. CIP is simply the most fundamental relationship linking money and foreign exchange markets in a financially open world.”

“For a given foreign currency and the U.S. dollar, a deviation from covered interest rate parity refers to the wedge between two rate differentials: (i) the difference between the n-period forward exchange rate and spot exchange rate… with both rates expressed in units of foreign currency per dollar; and (ii) the difference in the interest rates earned by holding the currencies…the n-period annualized interest rate difference between foreign and U.S. interest rates. In the absence of financial frictions, an arbitrageur could take advantage of the deviation from parity and earn a riskless profit. Alternatively, and equivalently if there are no frictions, no one would borrow dollars if it were cheaper to borrow foreign currency, buy dollars with the proceeds, and sell the dollars n periods forward for foreign currency (as in a foreign exchange swap) to repay the initial foreign-currency loan.”

Cross-currency dollar basis as a measure of broken arbitrage

“A negative dollar basis [means that] the FX forward implied interest rate differential of foreign currency versus USD is larger than the outright interest rate differential… A negative deviation suggests that direct dollar funding is cheaper than synthetic dollar funding that works by borrowing foreign currency and swapping it into dollars.”

“For about three decades until the global financial crisis [2008-09]…CIP appeared to hold quite closely…But as a growing number of studies document…the relationship seems to have broken down…That CIP deviations emerged in the turbulence of the global financial crisis is not so surprising, and is not unprecedented either. What has been more puzzling has been the continuation of CIP deviations – at times larger, at times smaller – well after the global financial crisis.”

“The evolution of the cross-currency dollar basis exhibits clear deviations from CIP after the crisis for both the short-term (first figure below) and long-term horizons. Before the global financial crisis, CIP deviations were very small and fluctuated around zero… During the global financial crisis, short-term CIP deviations reached levels of about -200 basis points, and more negative than -50 basis points at the five-year horizon (second figure below). While both three-month and five-year bases had been steadily reverting to near zero through 2013, they widened again after mid-2014. Most currencies have a negative dollar basis, implying a cost advantage for direct dollar funding, were it available at a marginal cost near Libor. “Carry” currencies such as the Australian and New Zealand dollars, on the other hand, display positive deviations from CIP… This sign indicates that direct U.S. dollar funding is costlier than synthetic funding based on swapping AUD or NZD borrowings into U.S. currency.”

Structural cause: regulatory tightening

“There is a consensus in the literature that structural factors, such as regulatory burdens, created limits to arbitrage allowing failures to profit from CIP deviations.”

“Structural factors, such as regulatory burdens, created limits to arbitrage allowing failures to profit from CIP deviations… Substantial volatility in cross-currency dollar bases after the crisis, coupled with tighter capital requirements (mostly in recent years), seem to have significantly pushed up the cost of arbitraging since the global financial crisis…Those few actors with the lowest dollar funding rates, who are in a position to engage in covered interest arbitrage, are constrained by regulatory factors.”

“Various banking regulatory instruments increase the cost of engaging in currency arbitrage…Higher bank balance sheet costs, along with an increasing demand for U.S. dollars due [for example] to monetary policy divergence, push up the price of dollar swaps and thus lead to the amplification of CIP deviations.”

Circumstantial factors

“Even though CIP’s breakdown is likely related to regulatory changes, the variation in CIP deviations seems also to be associated with multiple drivers across time… We find that those drivers can statistically explain the variation in CIP deviations since the global financial crisis. This is especially the case for the U.S. dollar strength and FX liquidity conditions, and to a lesser extent the VIX, especially in recent periods…

  • [There has been] a strong inverse relationship between the cross-currency dollar basis and dollar strength: the basis becomes more negative as the trade-weighted dollar strengthens [leading to] an increase in the cost of synthetic dollar borrowing via the swap market compared with direct dollar borrowing…The explanation [is] the interplay among dollar strength, bank leverage, and dollar credit. As the dollar strengthens non-U.S. residents’ balance sheets weaken, and this change impairs their ability to access dollar credit on favorable terms, allowing the absolute CIP deviation to rise.
    Before the global financial crisis, changes in dollar strength and risk sentiment have barely any power to affect the forward premium beyond the interest rate differential…[During] the peak crisis period, 2007-2009… changes in dollar strength are highly significant…they raise the cost of synthetic dollar borrowing compared with direct dollar funding…[During] the post-global financial crisis period, 2010-2018 the significance of dollar strength rises…
  • We use the log change in the U.S. VIX index to [proxy] global risk sentiment. In principle, heightened risk sentiment could deter covered interest arbitrage through a generalized retrenchment in balance sheets…[During] the post-global financial crisis period, 2010-2018 the significance of VIX rises… The coefficient of change in the log VIX index is most significant and largest in magnitude in the case of traditional safe haven currencies, CHF and JPY, possibly reflecting the higher hedging demand for dollar swaps of those currencies following rising volatilities and uncertainties…
  • We look at forward bid-ask spreads to capture liquidity in the FX market… The FX liquidity measure is only significant in the case of Swiss Franc, euro area, and overall panel…
  • Major central banks’ divergent monetary policy stances have widened cross-currency bases through several channels that raised the demand for swaps into U.S. dollars… Countries with lower interest rate tend to exhibit more negative cross-currency dollar bases… Domestic monetary easing widens the difference between foreign and domestic interest rates, so that global banks respond by increasingly borrowing from local-currency deposit facilities. This demand leads to a rise in currency hedging costs, contributing to the widening of cross-currency dollar bases…[Conversely] a larger difference between the deposit facility rate in the central bank where a foreign global bank is headquartered and leads to a decrease in the FX hedge demand, which would reduce a cross-country dollar negative basis
  • Our regressions also identify the recent October 2016 reform of U.S. prime money market fund as one temporary factor widening CIP deviations through a dramatic reduction in non-U.S. banks’ funding for currency arbitrage… a negative shock to prime money market fund holdings leads to a higher CIP deviation in favor of USD…[and as a consequence] a widening of cross-country dollar negative bases.”
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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.