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
JEL(s): F31, G15
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.