The Monetary Model of CIP Deviations

Ibhagui, Oyakhilome (2018): The Monetary Model of CIP Deviations.

Abstract

A large amount of currencies has over time exhibited persistent deviations from covered interest rate parity, resulting in non-zero cross-currency basis swap spreads. The relationship between these deviations and standard macroeconomic variables, however, remains unknown. In this paper, we document a long-run relationship between cross-currency basis swap spreads and macroeconomic variables (relative money supply and relative real output). After presenting a simple model where we relax the no-arbitrage CIP assumption in a monetary model framework, we empirically show that, in the long run, tighter cross-currency basis swap spreads are associated with higher relative real output for non-European currencies, while a rise in relative money supply does not widen the cross-currency basis swap spreads associated with European currencies. Our main results are robust to different estimation techniques and the inclusion of control variables. We also perform an error-correction analysis which suggests that the mechanism governing the adjustment to equilibrium is not the same for European and non-European currencies. More generally, we show that, when there is a move away from equilibrium, it is mostly the cross-currency basis swap spreads that adjust to ensure a return to equilibrium, across all maturities and samples.

• Item Type: MPRA Paper
• Language: English
• Keywords: Monetary fundamentals, covered interest rate parity, cross-currency basis swap spreads
• Subjects: F - International Economics > F3 - International Finance > F31 - Foreign Exchange

References

Avdjiev, Stefan, Wenxin Du, Catherine Koch, and Hyun Song Shin, 2016, The dollar, bank leverage and the deviation from covered interest parity, BIS Working Paper No. 592.

Baran, Jaroslav & Witzany, Jiri. (2017). Analyzing Cross-Currency Basis Spreads. ESM Working Paper 25-2017, European Stability Mechanism, Luxembourg.

Bilson, John. F. O., 1978. The monetary approach to the exchange rate–Some empirical evidence. International, Monetary Fund Staff Papers 25, 48—75.

Bahmani-Oskooee, Mohsen, and Satya P. Das, 1985, Transaction costs and the interest parity theorem, Journal of Political Economy 93, 793–799.

Baba, Naohiko, Frank Packer, and Teppei Nagano, 2008, The spillover of money market turbulence to FX swap and cross-currency swap markets, BIS Quarterly Review March 73–86.

Baba, Naohiko, Robert N. McCauley, and Srichander Ramaswamy, 2009, U.S. dollar money marketfunds and non-U.S. banks, BIS Quarterly Review March, 65.

Bottazzi, Jean-Marc, Jaime Luque, Mario Pascoa, and Suresh M. Sundaresan, 2012, Dollar short-age, central bank actions, and the cross-currency basis, Working paper, Paris School of Economics.

Callier, Philippe, 1981, One-way arbitrage, foreign exchange and securities markets: A note, Journal of Finance 36, 1177–1186.

Clinton, Kevin, 1988, Transactions costs and covered interest arbitrage: Theory and evidence, Journal of Political Economy 96, 358–370.

Coffey, Niall, Warren B. Hrung, and Asani Sarkar, 2009, Capital constraints, counterparty risk, and deviations from covered interest rate parity, Federal Reserve Bank of New York Staff Report 39.

Deardorff, Alan V., 1979, One-way arbitrage and its implications for the foreign exchange markets, Journal of Political Economy 87, 351–364.

Dooley, Michael P., and Peter Isard, 1980, Capital controls, political risk, and deviations from interest-rate parity, Journal of Political Economy 88, 370 – 384.

Dornbusch, Rudiger, 1976. Expectations and exchange rate dynamics. Journal of Political Economy 84(6), 1161—76.

Du, Wenxin, Alexander Tepper, and Adrien Verdelhan, 2016, Deviations from covered interest rate parity, Journal of Finance, VOL. LXXIII, NO. 3.

Frankel, Jacob A., 1979. On the mark: A theory of floating exchange rates based on real interest rate differentials. American Economic Review 69(4), 610—22.

Frenkel, Jacob. A., 1976. A monetary approach to the exchange rate: Doctrinal aspects and empirical evidence. Scandinavian Journal of Economics 78(2), 200—224.

Frenkel, Jacob A., and Richard M. Levich, 1975, Covered interest arbitrage: Unexploited profits? Journal of Political Economy 83, 325–338.

Gardeazabal Javier., Regúlez Marta, 1992, The Monetary Model of Exchange Rate Determination. In: The Monetary Model of Exchange Rates and Cointegration. Lecture Notes in Economics and Mathematical Systems, vol 385. Springer, Berlin, Heidelberg.

Griffolli, Mancini Tommaso, and Angelo Ranaldo, 2011, Limits to arbitrage during the crisis: Funding liquidity constraints and covered interest parity, Working paper, International Monetary Fund and University of St. Gallen.

Goldberg, Linda S., Craig Kennedy, and Jason Miu, 2011, Central bank dollar swap lines and overseas dollar funding costs, Federal Reserve Bank of New York Economic Policy Review.

Ivashina, Victoria, David S. Scharfstein, and Jeremy C. Stein, 2015, Dollar funding and the lending behavior of global banks, Quarterly Journal of Economics 130, 1241–1281.

Koepke, Robin. 2015. What Drives Capital Flows to Emerging Markets: A Survey of the Empirical Literature. IIF Working Paper, April, Washington DC.

McGuire, Patrick, and Goetz von Peter, 2012, The dollar shortage in global banking and the inter-national policy response, International Finance 15, 155-178.

Shinada, Naoki. (2005). Actual factors to determine cross-currency basis swaps: An empirical study on US dollar/Japanese yen basis swap rates from the late 1990s, Development Bank of Japan Working Paper.

Rime, Dagfinn, Andreas Schrimpf, and Olav Syrstad, 2016, Segmented money markets and covered interest parity arbitrage, BIS Working Paper No. 651.

Sushko, Vladyslav, Claudio Borio, Robert N. McCauley, and Patrick McGuire, 2016, The failure of covered interest parity: FX hedging demand and costly balance sheets, BIS Working Paper No. 590.

Liao, Gordon Y., 2016, Credit migration and covered interest rate parity, Harvard Business School Working Paper 2016-07.