Publication - The failure of covered interest parity: FX hedging demand and costly balance sheets
Figure 1. Dollar basis for select currency crosses and maturities
Figure 2. Measures of bank risk, volatility and uncertainty
Copyright: Centralbahnplatz 2 4051 Basel
Switzerland BISBCHBB
Website:www.bis.org
One of the most notable financial market anomalies in the post-great financial crisis (GFC) period has been the persistent violation of the no-arbitrage condition known as covered interest rate parity (CIP), or, equivalently, the persistence of a cross-currency basis.
In the past, CIP deviations were arbitraged almost instantly (Akram, Rime, and Sarno, 2008),1 with the exceptions of temporary episodes when arbitrage was inhibited by bank counterparty risks, during the Japan banking crisis (the “Japan premium”, Hanajiri (1999)) and, in addition, by wholesale US dollar funding strains, particularly during the GFC (Baba, McCauley, and Ramaswamy (2009), Coffey, Hrung, and Sarkar (2009), McGuire and von Peter (2012), Baba and Packer (2009), Cetorelli and Goldberg (2011) and Cetorelli and Goldberg (2012)) and during the euro area sovereign debt crisis (see Bottazzi, Luque, Pascoa, and Sundaresan (2012) and Ivashina, Scharfstein, and Stein (2015)). The basis then narrowed again when central banks provided US dollar funding and banks’ credit risk improved. Ivashina, Scharfstein, and Stein (2015) present a model where CIP deviations can arise when banks shift some of their funding away from wholesale funding markets due to default risk premia.
However, the CIP deviations in the post-2012 period have not coincided with a rise in bank credit risk or wholesale USD funding strains. We derive the cross-currency basis in a simple setup with limits to arbitrage (eg Shleifer and Vishny (1997), Gromb and Vayanos (2010)) to show that fluctuations in net currency hedging demand can cause CIP violations even in calm markets. This is because the balance sheet commitment to take the other side of net FX hedging imbalances so as to trade against CIP violations is costly. While balance sheet capacity has a number of dimensions, we focus on a specific setup that emphasizes the costs stemming from risks involved in taking exposures to FX derivatives.
This is because, regardless of the many ways in which CIP arbitrage can be funded, or foreign currency invested for the duration of the trade,2 all arbitrageurs would have to take positions in FX swaps or similar instruments. Balance sheet costs have become a binding constraint post-GFC. Prior to the crisis, for instance, the standard practice in the industry was to mark derivatives portfolios to market without taking the counterparty’s credit quality into account (Zhu and Pykhtin (2007)). This gave rise to bank trading models known as the “flow monster”, because balance sheets could be expanded virtually unconstrained in response to new flows hitting the swap trading desks. Following the crisis period of 2008-2011, the flow model has been replaced by a more cost sensitive approach of balance sheet management.3 In FX derivatives, this means that market risk and counterparty risk are being priced-in at all times, even when measured risks are low.4 Indeed, industry reports indicate that banks have been applying greater credit charges to swap pricing.5
Our theoretical setup seeks to capture these changes. The balance sheet costs of CIP arbitrage arise endogenously due to a combination of counterparty and market risk. This is because if the counterparty defaults on the forward leg an FX swap, then a CIP arbitrageur will face market risk from exposure to foreign currency collateral. As long as markets clear, the aggregate CIP arbitrageurs’ balance sheet exposure to FX swaps will exactly offset the net demand for FX swaps by those seeking to hedge currency risk. As a result, the currency basis responds to demand shocks to hedge currency risk forward and CIP can fail even in calm markets.
Empirically, we show that CIP deviations closely track the fluctuations in the net FX hedg- ing demand. Following Borio, McCauley, McGuire, and Sushko (2016), the typical sources for USD forward hedging demand include banks’ funding business models, institutional investors’ strategic hedging decisions and firms’ opportunistic securities issuance. These drivers are largely insensitive to the size of the basis (at least in the medium term), thereby representing an exogenous demand for forward USD hedges.
This demand pushes down the dollar price of foreign currency in spot markets and pushes up the dollar price of foreign currency in the forward markets. On the other side of the market, the balance sheet costs of meeting net FX hedging demand to arbitrage the resulting currency basis are priced into the forward exchange rates by CIP arbitrageurs, and therefore prevent CIP from being fully restored.
Copyright: Centralbahnplatz 2 4051 Basel
Switzerland BISBCHBB
Website:www.bis.org
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