Inflation Differential as a Driver of Cross-currency Basis Swap Spreads

Ibhagui, Oyakhilome (2020): Inflation Differential as a Driver of Cross-currency Basis Swap Spreads.

Abstract

Over the last decade, the foreign exchange derivatives market has witnessed a collapse of covered interest parity (CIP). Not only does this collapse give rise to large deviations from CIP, it has unlocked a stream of exploitable arbitrage opportunities across currencies. In this paper, we introduce two new factors - inflation differential and relative economic performance - as potential drivers of deviations from CIP. Employing data on G10 cross-currency basis swap spreads viz a viz the U.S. dollar, we document a striking new evidence that higher inflation differential and incremental improvement in relative economic performance drive the basis wider, and hence arbitrage profits higher for U.S. dollar investors, in the post crisis period. Our main empirical results in general are robust to an extended number of controls, variations in sampling frequency, and consideration of alternative specifications, but the additional explanatory power is low.

• Item Type: MPRA Paper
• Language: English
• Keywords: Cross-currency basis, inflation differential, relative economic performance
• Subjects: F - International Economics > F3 - International Finance

References

1. Arai, T., Y. Makabe, Y. Ookawara, and T. Nagano. (2016). Recent Trends in Cross-Currency Basis. Bank of Japan Review No. 2016-E-7.

2. Avdjiev, S., Du, W., Koch, C., and Shin, H. S. (2019). The Dollar, Bank leverage and the Deviation from Covered Interest Parity. American Economic Review: Insights, Forthcoming

3. Amano, R, and Ambler, S. (2014). Price-Level Targeting and the Zero Lower Bound (Technical Report). Bank of Canada and Université du Québec à Montréal.

4. Baba, N., and Packer, F. (2009). Interpreting Deviations from Covered Interest Parity during the Financial Market Turmoil of 2007–08. Journal of Banking and Finance 33 (11): 1953-62.

5. Baran, J and Witzany, J. (2017). Analyzing Cross-Currency Basis Spreads. ESM Working Paper 25-2017, European Stability Mechanism, Luxembourg.

6. Boons, M., Duarte, F., de Roon, F., & Szymanowska, M. (2019). Time‐varying inflation risk and stock returns. https://www.sciencedirect.com/science/article/pii/S0304405X19302429

7. Borio, C E.V., Iqbal, M., McCauley, R. N., McGuire, P.M., and Sushko, V., (2018). The Failure of Covered Interest Parity: FX Hedging Demand and Costly Balance Sheets. BIS Working Papers No. 590. Available at SSRN: https://ssrn.com/abstract=2910319 or http://dx.doi

8. Chen, H. (2010). Macroeconomic conditions and the puzzles of credit spreads and capital structure, Journal of Finance, 65(6), 2171–2212

9. Courcel, C, (2015, 2017). Cross-currency basis swaps: A primer Special focus on EUR/USD – Edition 1 & 2, BNP Paribas Strategy Desknote Europe, G10 Strategy.

10. Cheung, Y-W & Qian, X 2011.Deviations from covered interest parity: The case of China.” in „The Evolving Role of Asia in Global Finance.” vol. 9, Frontiers of Economics and Globalization, vol. 9, Emerald Group Publishing Ltd., pp. 369-386.

11. Czech, K., (2017). Extracting Market Expectations from Currency Options’ Risk Reversals. Annales Universitatis Mariae Curie-Skłodowska Lublin – Polonia Vol. Li, 6 Sectio H Du, W, Tepper, A, & Verdelhan, A, (2018). Deviations from Covered Interest Parity, Journal of Finance, Vol. LXXIII, NO. 3

12. Engel, C., D. Lee, C. Liu, C. Liu, and S. P. Y. Wu (2018): The Uncovered Interest Parity Puzzle, Exchange Rate Forecasting, and Taylor Rules, Working Paper, University of Wisconsin.

13. Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of political economy, 81(3), 607-636.

14. Hui, C., H. Genberg and T. Chung (2010). Funding liquidity risk and deviations from interest-rate parity during the Financial crisis of 2007 – 2009. International Journal of Finance & Economics. n/a, doi: 10.1002/ijfe.427

15. Ibhagui, O., (2018). The Monetary Model of CIP Deviations, Working Paper, Munich Personal RePEc Archive.

16. Ibhagui, O., (2019). Eurozone Real Output and Covered Interest Parity Deviations: Can Stronger Real Output Lessen the Deviations? Working Paper, Munich Personal RePEc Archive

17. Ibhagui, O., (2019). Wider Covered Interest Parity Deviations and Lower Stock Returns: Evidence from the Eurozone. Working Paper, Munich Personal RePEc Archive

18. Ivashina, V., D.S. Sharfstein, and J.C. Stein. 2015. Dollar Funding and the Lending Behavior of Global Banks Quarterly Journal of Economics 130 (3): 1241-81.

19. Kohler, D., and B. Muller (2018): Covered Interest Rate Parity, Relative Funding Liquidity and Cross-Currency Repos, typescript, Swiss National Bank.

20. Liao, G. (2016). Credit migration and covered interest rate parity. Working Paper.

21. Nakaso, H. (2017). Monetary Policy Divergence and Global Financial Stability. Speech by the Deputy Governor of the Bank of Japan at a meeting hosted by the International Bankers Association of Japan, Tokyo, January 20.

22. Pozsar, Z. 2016. Global Money Notes #8: From Exorbitant Privilege to Existential Trilemma. Credit Suisse.

23. Rime, D., and Schrimpf, A., and Syrstad, O. (2019). Covered Interest Parity Arbitrage. BIS Working Paper Available at SSRN: https://ssrn.com/abstract=2879904 or http://dx.doi.org/10.2139/ssrn.2879904

24. Wong, A., and J. Zhang (2018): Breakdown of Covered Interest Parity: Mystery or Myth?” typescript Wong, A., D. Leung, and C. Ng (2016): Risk-adjusted Covered Interest Parity: Theory and Evidence, Working Paper 16, HKIMR