Deviations from Covered Interest Rate Parity

• Published date: 01 June 2018
• DOI: http://doi.org/10.1111/jofi.12620
• Author: ADRIEN VERDELHAN,ALEXANDER TEPPER,WENXIN DU
• Date: 01 June 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 3 •JUNE 2018

Deviations from Covered Interest Rate Parity

WENXIN DU, ALEXANDER TEPPER, and ADRIEN VERDELHAN∗

ABSTRACT

We find that deviations from the covered interest rate parity (CIP) condition imply

large, persistent, and systematic arbitrage opportunities in one of the largest asset

markets in the world. Contrary to the common view,these deviations for major curren-

cies are not explained away by credit risk or transaction costs. They are particularly

strong for forward contracts that appear on banks’ balance sheets at the end of the

quarter, pointing to a causal effect of banking regulation on asset prices. The CIP

deviations also appear significantly correlated with other fixed income spreads and

with nominal interest rates.

THE FOREIGN EXCHANGE (FX) FORWARD AND swap market is one of the largest

and most liquid derivative markets in the world, with a total notional amount

outstanding equal to $61 trillion and average daily turnover equal to $3 trillion

(Bank of International Settlements (2013, 2014)). The cornerstone of currency

forward and swap pricing, presented in all economics and finance textbooks

and taught in every class in international finance, is the covered interest rate

parity (CIP) condition. In this paper, we document deviations from the CIP in

the postcrisis period and investigate the causes of such deviations.

∗Wenxin Du is with the Federal Reserve Board. Alexander Tepperis with the Columbia Gradu-

ate School of Architecture, Planning and Preservation. A large part of this research was conducted

while Alexander Tepper was working at the Federal Reserve Bank of New York. Adrien Verdelhan

is with MIT Sloan and NBER. The authors thank the Editor, Stefan Nagel, and two anonymous

referees. The views in this paper are solely the responsibility of the authors and should not be

interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or

any other person associated with the Federal Reserve System. We thank Claudio Borio, Fran-

cois Cocquemas, Pierre Collin-Dufresne, Doug Diamond, Charles Engel, Xavier Gabaix, Benjamin

Hebert, Sebastian Infante, Arvind Krishnamurthy, Martin Lettau, Hanno Lustig, Matteo Mag-

giori, Robert McCauley, Tyler Muir, Warren Naphtal, Brent Neiman, Pierre-Olivier Gourinchas,

Jonathan Parker, Thomas Philippon, Arvind Rajan, Adriano Rampini, Fabiola Ravazzolo, Andrew

Rose, Hyun Song Shin, Jeremy Stein, Steve Strongin, Saskia ter Ellen, Fabrice Tourre, Annette

Vissing-Jorgensen, and seminar and conference participants at the AFA meeting in Chicago, the

Bank of Canada, the Bank of England, the Bank for International Settlements, Berkeley,Chicago,

the European Central Bank, the Federal Reserve Board, the Federal Reserve Bank of Dallas, the

Federal Reserve Bank of Philadelphia, the Federal Reserve Bank of San Francisco, Harvard, the

International Monetary Fund, MIT Sloan, the NBER Summer Institute, Northwestern, Stanford

GSB, UNC Chapel Hilll, Wisconsin-Madison, Wharton, Vanderbilt, and Washington University

for comments and suggestions. All remaining errors are our own. The paper previously circulated

under the title “Cross-currency Basis.” We have read the Journal of Finance’sdisclosure policy and

have no conflicts of interest to disclose.

DOI: 10.1111/jofi.12620

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916 The Journal of Finance R

We first show that the CIP condition has been systematically and per-

sistently violated among G10 currencies since the global financial crisis in

2008, leading to significant arbitrage opportunities in currency and fixed in-

come markets. This finding is a puzzle for no-arbitrage models in macroeco-

nomics and finance. Since the arbitrage opportunities exist at a very short

horizon, such as overnight or at the one-week horizon, this finding is also a

puzzle for the classic limits-of-arbitrage models that rely on long-term mar-

ket risk, as in Shleifer and Vishny (1997). The systematic patterns of the

CIP violations point to a key interaction between costly financial intermedia-

tion and international imbalances in funding supply and investment demand

across currencies in the new, postcrisis regulatory environment. In particu-

lar, we provide evidence of the impact of postcrisis regulatory reforms on CIP

arbitrage.

The intuition for the CIP condition relies on a simple no-arbitrage condition.

For example, an investor with U.S. dollars in hand today may deposit her dol-

lars for one month, earning the dollar deposit rate. Alternatively, the investor

may exchange her U.S. dollars for some foreign currency, deposit the foreign

currency,and earn the foreign currency deposit rate for one month. At the same

time, the investor can enter into a one-month currency forward contract today,

which would convert the foreign currency earned at the end of the month into

U.S. dollars. If both U.S. and foreign currency deposit rates are default-free and

the forward contract has no counterparty risk, the two investment strategies

are equivalent and thus should deliver the same payoffs. Therefore, the differ-

ence between U.S. dollar and foreign currency deposit rates should be exactly

equal to the cost of entering the forward contract, that is, the log difference

between the forward and the spot exchange rates, with all rates observed at

the same date.

The cross-currency basis measures the deviation from the CIP condition. It is

the difference between the direct dollar interest rate from the cash market and

the synthetic dollar interest rate obtained by swapping the foreign currency

into U.S. dollars. A positive (negative) currency basis means that the direct

dollar interest rate is higher (lower) than the synthetic dollar interest rate.

When the basis is zero, CIP holds. Before the global financial crisis, the log

difference between the forward rate and the spot rate was approximately equal

to the difference in London interbank offered rates (Libor) across countries

(Frenkel and Levich (1975), Akram, Rime, and Sarno (2008)). In other words,

the Libor cross-currency basis was very close to zero. As is now well known,

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.

We show that Libor bases persist after the global financial crisis among G10

currencies and remain large in magnitude. Our sample includes the most liquid

currencies, with a total daily turnover above $2 trillion (Bank of International

Settlements (2013)): the Australian dollar, Canadian dollar, Swiss franc, Dan-

ish krone, euro, British pound, Japanese yen, Norwegian krone, New Zealand

dollar, and Swedish krona. The average annualized absolute value of the basis

Deviations from Covered Interest Rate Parity 917

is 24 basis points (bps) at the three-month horizon and 27 bps at the five-year

horizon over the 2010 to 2016 sample.1These averages hide large variations

both across currencies and over time. In the current economic environment,

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 bps at the end of 2015, which was even greater in magnitude than

the difference (of about −70 bps) between the five-year Libor interest rate in

Japan and in the United States.

We show that credit risk in the Libor market and the indicative nature

of Libor cannot explain away the persistence of the cross-currency basis. A

common explanation for CIP deviations is that interbank panels have differ-

ent levels of creditworthiness (e.g., Tuckman and Porfirio (2004)). If, for ex-

ample, interbank lending in yen entails higher credit risk (due to the 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 need not be

zero.2Studying the credit default spreads of banks on interbank panels in

different currencies, we do not find much support for this explanation of CIP

deviations.

More crucially, we document that the currency basis exists even in the ab-

sence of any credit risk difference across countries and for actual interest rate

quotes. To do so, we first examine general collateral (GC) repurchase agree-

ments (repo) and then Kreditanstalt f ¨

ur Wiederaufbau (KfW) bonds issued in

different currencies. Repo contracts are fully collateralized and thus do not

exhibit any credit risk. KfW bonds are fully backed by the German government

and thus exhibit very minimal credit risk, without differences in credit risk

across currencies. Repo and forward contracts highlight the CIP deviations at

the short end of the yield curves, while KfW bonds and swaps focus on longer

maturities. We find that the repo currency basis is persistently and signifi-

cantly negative for the Japanese yen, the Swiss franc, and the Danish krone,

and that the KfW basis is also significantly different from zero for the euro, the

Swiss franc, and the Japanese yen, even after taking into account transaction

costs.

The CIP deviations thus lead to persistent arbitrage opportunities free from

exchange rate and credit risks. For example, a long-short arbitrageur may

borrow at the U.S. dollar repo rate or short U.S. dollar-denominated KfW

bonds and then earn risk-free positive profits by investing in repo rates or KfW

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 FX forwards or swaps. The net arbitrage profits range from 10 to 20 bps

1One-hundred basis points equal 1%.

2“Libor” rates measure the interest rates at which Libor panel banks borrow from each other.

In this paper, we use the term “Libor” loosely to refer to the benchmark unsecured interbank

borrowing rate, which can be determined by local interbank panels rather than the British Banker

Association (now Intercontinental Exchange) Libor panels.