Working Paper: NBER ID: w27231
Authors: Patrick Augustin; Mikhail Chernov; Lukas Schmid; Dongho Song
Abstract: We quantify the impact of risk-based and non-risk-based intermediary constraints (IC) on the term structure of CIP violations. Using a stochastic discount factor (SDF) inferred from interest rate swaps, we value currency derivatives. The wedge between model-implied and observed derivative prices reflects the impact of non-risk-based IC because our SDF incorporates risk-based IC. There is no wedge at short horizons, while the wedge accounts for 40% of long-term CIP violations. Consistent with IC theory, the wedge correlates with the shadow cost of intermediary capital, and the SDF-implied interest rate is a weighted average of collateralized and uncollateralized interest rates.
Keywords: intermediary constraints; covered interest parity; stochastic discount factor; currency derivatives; cross-currency basis swaps
JEL Codes: C01; E43; E44; G12; H60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Intermediary Constraints (D20) | CIP Violations (K42) |
| Wedge (Y60) | Shadow Cost of Intermediary Capital (G19) |
| Risk-based IC (G24) | Wedge at Short Horizons (G19) |
| Risk-based Model (C52) | Variation in XCCY Rates (J79) |
| Non-risk-based IC (G22) | Differences in XCCY Premiums (G52) |