Why the covered interest parity is breaking down

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Deviations in the covered interest parity have become a regular phenomenon even in developed markets. Persistent gaps between on-shore and FX-implied interest rate differentials (“cross-currency basis”) can be explained by the combination of increased cost of financial intermediation in the wake of regulatory reform and global imbalances in investment demand and funding supply. They can offer information value and arbitrage opportunities for investors.

Du, Weixin, Alexander Tepper and Adrien Verdelhan (2016), “Deviations from Covered Interest Rate Parity”.
Shin, Hyun Song (2016), “Global liquidity and pro-cyclicality”, Speech at the World Bank conference “The state of economics, the state of the world”, Washington DC, 8 June 2016.

This post ties in with the subject of price distortions and market liquidity, which is explained on the price distortions summary page.

The below are mostly excerpts from the Du et al. research paper. Quotes from Hyung Song Shin’s speech are specially marked.

Covered interest parity

“The cornerstone of currency forward and swap pricing …is the covered interest parity (CIP) condition. According to the CIP condition, the log difference between the currency forward rate and the spot rate…should be equal to the interest rate difference between the two countries over the horizon of the forward contract.”

“The CIP condition is… a simple no-arbitrage condition… From the borrower’s perspective, the cost of funding directly in dollars should be exactly equal to the combined cost of funding in a foreign currency and swapping the funds into dollars. From the investor’s perspective, the yield on a dollar asset should be exactly equal to the yield on a foreign currency asset after hedging currency risk, provided that the two assets have the same risk characteristics except different currency denomination…Equivalently, the CIP condition links exchange rate swap rates to forward and spot rates and yield curve differences across countries.”

“The intuition for the CIP condition is simple: an investor with U.S. dollars in hand today may invest in one-month U.S. Treasury bills. But the investor may also exchange her U.S. dollars for some foreign currency and invest in one-month foreign Treasury bills. A one-month currency forward contract signed today would convert the foreign currency earned at the end of the month into U.S. dollars. If both domestic and foreign Treasury bills exhibit the same amount of risk and the forward contract has no counterparty risk, the two investment strategies are equivalent.”

Cross-currency basis

“The cross-currency basis measures CIP deviations…The cross-currency basis measures the…difference between the direct dollar interest rate and the synthetic dollar interest rate obtained by swapping the foreign currency into U.S. dollars.”

N.B.: From the angle of a dollar borrower a negative cross-currency basis means that it is cheaper to borrow directly in the dollar market than indirectly through foreign currency borrowing and FX hedging. From the angle of a dollar-based foreign currency investor a negative cross-currency basis means that the carry obtained through an FX forward is less than one obtained through a combined transaction that borrows in dollar and lends in foreign currency.

At the longer maturities (typically one year or greater), CIP violations based on Libor are directly quoted as spreads on cross-currency basis swaps.…A cross-currency basis swap involves an exchange of cash flows linked to floating interest rates in two different currencies, as well as an exchange of principal in two different currencies at the inception and the maturity of the swap. The most common interest rates used to define the cross-currency basis swap contracts are the Libor [unsecured interbank] rates.”

Evidence of breakdowns

“Before the global financial crisis…the Libor cross-currency basis was very close zero…Large bases appeared during the height of the global financial crisis and the European debt crisis, as the interbank markets became impaired and arbitrage capital was limited. Libor bases persist after the global financial crisis among G10 currencies and remain large in magnitude…The average annualized absolute value of the basis is 24 basis points at the three-month horizon and 26 basis points at the five-year horizon over the 2010–2015 sample. These averages hide large variation both across currencies and across time…The cross-currency basis can be of the same order of magnitude as the interest rate differential. For example, the five-year basis for the Japanese yen was close to -90 basis points at the end of 2015, which was even greater in magnitude than the difference (of about -70 basis points) between the five-year Libor interest rate in Japan and in the U.S.”

“[The graph below]…plots the value of the US dollar (in blue), calculated as the simple average of the exchange rates against six advanced economy currencies as indicated. When the blue line goes up, the dollar strengthens. On the same chart, plotted (in red) is the average cross currency basis. Notice how the cross-currency basis is the mirror image of the strength of the dollar. When the dollar strengthens, the cross-currency basis widens. This is especially so in the last 18 months or so, reflecting the stronger dollar.” [Shin]

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“The relationship is even clearer if we plot changes in exchange rates and changes in the cross currency basis. The graph below shows this for the bilateral exchange rate of the euro against the dollar.” [Shin]

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Interbank credit issues

“Contrary to a common view… the deviations from the covered interest parity condition are not explained away by credit risk or transaction costs.
A common explanation for CIP deviations is that Libor panels have different levels of credit worthiness. If, for example, interbank lending in yen entails a higher credit risk (due to the average lower credit quality of yen Libor banks) than interbank lending in U.S. dollars, the lender should be compensated for the credit risk differential between yen Libor and dollar Libor, and thus the cross-currency basis can persist.”

“However, we do not find any economically significant link between the Libor cross-currency basis and the average credit default swap differential between interbank panels…[Also,] we document that the currency basis exists even in the absence of any credit risk difference across countries and for actual interest rate quotes… At short maturities, one way to eliminate the credit risk associated with Libor-based CIP is to use secured borrowing and lending rates from the repo markets. We thus use general collateral repo rates in U.S. dollars and foreign currencies to construct an alternative currency basis measure. A general collateral repo is a repurchase agreement in which the cash lender is willing to accept a variety of Treasury and agency securities as collateral…We find that the repo currency basis is persistently and significantly negative for the Japanese yen, the Swiss franc and the Danish krone.”

Regulatory reform

“If financial intermediaries were unconstrained, the supply of currency hedging should be perfectly elastic, and any CIP deviations would be arbitraged away.”

“Before the global financial crisis, global banks actively arbitraged funding costs across currencies…Since the crisis, a wide range of regulatory reforms has significantly increased the banks’ balance sheet costs associated with arbitrage and market making activities…

  • Global banks face significantly higher capital requirements since the global financial crisis. The minimum common equity Tier 1 capital ratio against risk-weighted assets (RWA) increased from 2% to 7%. In addition…the central component of the RWA calculation for a CIP trade is the 99% Value-at-Risk (VaR) measure…[and] the cross-currency basis became significantly more volatile after the crisis, thus increasing the VaR on the CIP trade…Capital charges against the five-year CIP trade increase dramatically from less than 4% before the crisis to more than 35% of the trade…In other words, banks engaging in CIP arbitrages could trade a volume equal to 25 times their equity before the crisis; now, they can only trade a volume equal to three times their equity
  • The supplemental leverage ratio requires banks to hold a minimum amount of [3%] capital against all on-balance-sheet assets and off-balance-sheet exposure, regardless of their risk…If we assume that banks need to hold 3% of their capital against the CIP arbitrage trades and that their overall objective in terms of rates of return on capital is around 10%, then banks need at least a 3% times 10%, i.e. 30 basis point cross-currency basis to engage in the trade…Many of the arbitrage opportunities that we document may not be attractive enough for banks: CIP arbitrage has become balance sheet-intensive post crisis.
  • A host of other financial regulations have also reduced banks’ willingness to engage in CIP arbitrage. For example, the Volcker Rule as a part of the Dodd-Frank act forbids banks to actively engage in proprietary trading activities. Proprietary trading in spot exchange rates is allowed, but not in exchange rate forwards and swaps…In addition, the over-the-counter derivative reform set higher capital and minimum margin requirements for cross-currency swaps, which are generally un-cleared, further increasing the capital on the CIP trade.”

Imbalances

“If the global funding and investment demand were balanced across currencies, there would be no [net] client demand for FX swaps to transform funding liquidity or investment opportunities across currencies.”

Countries with high nominal interest rates (Australia and New Zealand) exhibit negative net international investment positions and are importers of capital, whereas countries with low nominal interest rates (Japan and Switzerland) exhibit positive net international investment positions and are exporters of capital…If investors willing to transfer capital across countries do not bear all exchange rate risk, such global imbalances affect the demand for currency hedging, and thus the demand for exchange rate forwards and swaps.”

“An exchange rate swap market maker takes the opposite direction of the trade but does not want to bear any currency risk. To do so, the swap market maker hedges the currency exposure in the cash market by going long in high interest rate currencies, and short in low interest rate currencies. The profit per unit of notional is equal to the absolute value of the cross-currency basis [and hence the more profit the market maker needs to justify the trade the larger the basis].”

Patterns

“CIP deviations exhibit [several important] characteristics…

  • The cross-currency basis is positively correlated with the level of nominal interest rates…high interest rate currencies tend to exhibit positive basis while low interest rate currencies tend to exhibit negative ones…In time-series, the currency basis tends to increase with interest rate shocks…The intuition…is that the lower the interest rate, the higher the excess demand to swap foreign currency funding into the U.S. dollar funding. A capital-constrained arbitrageur charges higher excess returns for taking the opposite of the trade…which corresponds to a more negative basis….
  • The magnitude of the CIP deviation is larger at quarter ends, when the cost of balance sheet may be higher due to quarterly regulatory reporting. The quarter-end anomaly is featured in the post-2007 sample, but is absent from the pre-2007 sample…
  • The cross-currency basis is correlated with other liquidity risk premia…[and] other fixed income arbitrage bases…The co-movement in bases measured in different markets supports the role of financial intermediaries and likely correlated demand shocks for dollar funding and other forms of liquidity.”

“There is a “triangle” that links a stronger dollar, more subdued dollar cross-border flows, and a widening of the cross-currency basis against the dollar…The key feature of the risk-taking channel is that when the dollar depreciates, banks lend more in US dollars to borrowers outside the United States. Similarly, when the dollar appreciates, banks lend less, or even shrink outright the lending of dollars. In this sense, the value of the dollar is a barometer of risk-taking and global credit conditions…The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting a squeeze on accumulated dollar liabilities built up during the previous period of easy dollar credit.” [Shin]

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Opportunities

“Since the global financial crisis, there are large and persistent arbitrage opportunities in one of the largest asset markets in the world because the CIP condition does not hold any more.”

“A long-short arbitrageur may for example borrow at the U.S. dollar repo rate or short U.S. dollar-denominated [AAA-rated quasi sovereign] bonds and then earn risk-free positive profits by investing in repo rates or [AAA-rated quasi sovereign] bonds denominated in low interest rate currencies, such as the euro, the Swiss franc, the Danish krone or the yen, while hedging the foreign currency risk using foreign exchange forwards or swaps. The net arbitrage profits range from 6 to 19 basis points on average in annualized values. The averages may appear small, but again they hide large time variations: the standard deviation of the net arbitrage profits range from 4 to 23 basis points. Moreover, the conditional volatility of each investment opportunity is naturally zero and Sharpe ratios are thus infinite.”

“Relative to the synthetic dollar rate obtained by swapping foreign currency interest rates, foreign banks generally borrow in U.S. dollars directly at higher costs, whereas U.S. banks and supranational institutions generally borrow in U.S. dollar directly at lower costs. As a result, the U.S. banks and supranational institutions are in the best position to arbitrage the negative cross-currency basis, especially during periods of financial distress.”