Deviations from Covered Interest Rate Parity

Covered interest rate parity is the no-arbitrage relation that pins the forward exchange rate to the spot rate and the interest differential; the paper’s own description is that it is “presented in all economics and finance textbooks and taught in every class in international finance.” This paper documents that it is systematically and persistently violated among G10 currencies after the 2008 crisis, establishes that the violations are genuine arbitrage rather than compensation for credit risk or transaction costs, and traces them to the cost of using a bank balance sheet. (The magnitudes cited here come from the February 2017 NBER working-paper version, the freely available full text this summary rests on; the published version appeared in the Journal of Finance in 2018.) The scale of the market matters for how surprising this is: $61 trillion notional outstanding and $3 trillion average daily turnover. Over 2010-2016 the average annualised absolute Libor cross-currency basis is 24 basis points at three months and 27 basis points at five years, but those averages conceal a lot – the five-year yen basis was close to -90 basis points at the end of 2015, larger in magnitude than the roughly -70 basis point five-year Libor differential between Japan and the United States. Two moves rule out the standard explanations. The credit-risk story, that interbank panels differ in creditworthiness, is tested directly on panel banks’ CDS spreads and finds little support; more decisively, the authors recompute the basis on instruments with no credit-risk difference at all – general collateral repos, which are fully collateralised, and Kreditanstalt für Wiederaufbau bonds, fully backed by the German government – and the basis survives. The repo basis is persistently and significantly negative for the yen, Swiss franc and Danish krone, ranging from -16 basis points for the euro to -36 for the Danish krone, and the KfW basis is significantly non-zero for the euro, Swiss franc and yen (about -14, -24 and -30 basis points) while being effectively zero for the Australian dollar. Net of measured transaction costs, the resulting arbitrage profits run from 9 to 20 basis points annualised, with standard deviations of 5 to 23 basis points – small numbers, but with zero conditional volatility over the fixed investment horizon, so the Sharpe ratios are infinite. On explanation, the paper advances a two-factor hypothesis: costly post-crisis financial intermediation, which explains why the deviations are not arbitraged away, plus persistent international imbalances in funding supply and investment demand across currencies, which explains why the basis lines up with the level of nominal rates. Four empirical characteristics follow. First, the deviations spike at quarter ends, and the timing is sharp in a way that identifies the mechanism: the one-month deviation jumps exactly one month before quarter end, the one-week deviation exactly one week before, while a three-month contract – which appears on a quarter-end report whenever it is executed – shows no such pattern. Second, using the Fed’s interest on excess reserves in place of Libor/OIS/repo as the direct dollar funding cost, as a proxy for the shadow cost of leverage, explains about one-third of the one-week deviations; also investing at foreign central banks’ deposit facilities shrinks the average basis from -26 (Libor) and -28 (OIS) basis points to -8, which the conclusion describes as accounting for two-thirds of the deviations – while still leaving -12 to -15 basis points for the krone, franc and yen. Third, the basis is positively correlated with the level of nominal interest rates, with a 89 percent correlation between five-year Libor bases and five-year Libor rates across G10 currencies, so the hedged arbitrage trade is long low-rate and short high-rate currencies – exactly the reverse of the unhedged carry trade. Fourth, the basis co-moves with other near-risk-free fixed-income spreads, notably the KfW-over-bund basis and the US Libor tenor basis. The authors are careful about what they have and have not shown: they present “the first international evidence on the causal impact of recent banking regulation on asset prices,” but state that assessing the welfare cost “is behind the scope of this paper; it would necessitate a general equilibrium model.”

Alexander Tepper | Macro Paper Warehouse

Deviations from Covered Interest Rate Parity