Working Paper: NBER ID: w26129
Authors: Eugenio M. 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. Postcrisis 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 the 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; Macrofinancial Factors; Global Financial Crisis; Exchange Rates; Monetary Policy
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 and policy-related factors (G52) | Evolution of CIP deviations (L15) |
| Key measures of foreign exchange market liquidity and risk-taking capacity of intermediaries (F31) | Cross-currency basis (F31) |
| Broad US dollar strength (F31) | Cross-currency basis (F31) |
| Post-crisis monetary policies (E52) | CIP deviations (L15) |
| Risk-related factors (G41) | CIP deviations (L15) |
| Financial regulations targeting globally systemically important financial institutions (G28) | Year-end dynamics of the three-month dollar basis (E43) |