Working Paper: CEPR ID: DP13886
Authors: Eugenio Cerutti; Maurice Obstfeld; Haonan Zhou
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.
Keywords: covered interest parity; interest rate differentials; forward FX market
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Changes in risk-related factors (D91) | CIP deviations (L15) |
| Changes in policy-related factors (O24) | CIP deviations (L15) |
| Foreign exchange market liquidity (G15) | CIP deviations (L15) |
| Intermediaries' risk-taking capacity (G21) | CIP deviations (L15) |
| Post-crisis monetary policies (E52) | CIP deviations (L15) |
| Central bank balance sheets (E58) | CIP deviations (L15) |
| Term premia (Y20) | CIP deviations (L15) |
| Bank regulation (G28) | CIP deviations (L15) |
| Financial regulations targeting G-SIBs (G28) | Year-end dynamics of the three-month dollar basis (E43) |
| Broad US dollar strength (F31) | Cross-currency basis (F31) |