DP13886 Covered Interest Parity Deviations: Macrofinancial Determinants
|Author(s):||Eugenio Cerutti, Maurice Obstfeld, Haonan Zhou|
|Publication Date:||July 2019|
|Date Revised:||August 2020|
|Keyword(s):||Covered Interest Parity, forward FX market, Interest Rate Differentials|
|Programme Areas:||International Macroeconomics and Finance|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=13886|
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.