Working Paper: CEPR ID: DP18648
Authors: Philippe Bacchetta; J. Scott Davis; Eric van Wincoop
Abstract: Recent theories of exchange rate determination have emphasized limited UIP arbitrage by international financial institutions. New regulations since 2008 have also lead to imperfect CIP arbitrage. We show that under limited CIP arbitrage the exchange rate and CIP deviation are jointly determined by equilibrium in the FX spot and swap markets. The model is used to investigate the impact of a wide range of financial shocks. The exchange rate is affected by a new set of financial shocks that operate through the swap market, which have no effect under perfect CIP arbitrage. More familiar financial shocks that impact the spot market have an amplified effect on the exchange rate as a result of their feedback to the swap market. Implications of the model are consistent with a broad range of evidence.
Keywords: Dollar shortages; CIP deviations; Safe haven; Risk aversion; Central bank swap lines
JEL Codes: F31; F32; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in risk or risk aversion since 2007 (D81) | US dollar appreciation (F31) |
| Increase in risk or risk aversion since 2007 (D81) | Greater deviations from covered interest parity (CIP) (F31) |
| Dollar shortages in offshore markets (F31) | Increased CIP deviations (L15) |
| Dollar shortages in offshore markets (F31) | US dollar appreciation (F31) |
| Conditions in the offshore dollar funding market (F65) | Changes in CIP deviation (L15) |
| Conditions in the offshore dollar funding market (F65) | Changes in exchange rate (F31) |
| Central bank swap lines (F33) | Alleviate dollar shortages (F31) |
| Central bank swap lines (F33) | Limit CIP deviations (L15) |
| Increased financial stress (G59) | Higher CIP deviation (L15) |
| Increased financial stress (G59) | US dollar appreciation (F31) |