Munich Personal RePEc Archive

The Monetary Model of CIP Deviations

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

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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.

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