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Title: Covered Interest Parity Deviations: Macrofinancial Determinants

Author(s): Eugenio Cerutti, Maurice Obstfeld and Haonan Zhou

Publication Date: July 2019

Keyword(s): Covered Interest Parity, forward FX market and Interest Rate Differentials

Programme Area(s): International Macroeconomics and Finance

Abstract: This paper studies how several macrofinancial factors are associated over time with the evolution of covered interest parity (CIP) deviations in the decade after the Global Financial Crisis. Changes in a number of risk- and policy-related factors have a significant association with the evolution of CIP deviations. Key measures of FX market liquidity and intermediaries' risk-taking capacity are strongly correlated with the cross-currency basis (the deviation from CIP), and the close relationship between broad U.S. dollar strength and the basis is driven mainly by a common factor depending on other safe-haven currencies' comovements. Post-crisis monetary policies also play a role, as demonstrated by the relationship between CIP deviations, central bank balance sheets, and term premia. Risk-related factors have more explanatory power than monetary policy-related factors over the entire 2010-2018 period, but they are approximately equally influential over that period's second half. Further highlighting the role of bank regulation, we offer evidence that the year-end dynamics of the three-month dollar basis depend on financial regulations targeting global systemically important financial institutions.

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Bibliographic Reference

Cerutti, E, Obstfeld, M and Zhou, H. 2019. 'Covered Interest Parity Deviations: Macrofinancial Determinants '. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13886