Deviations from Covered Interest Rate Parity

2017 FIRST PRIZE

Wenxin Du, Ph.D., Federal Reserve Board; Alexander Tepper, Ph.D., Columbia University; and Adrien Verdelhan, Ph.D., MIT Sloan School of Management 

Covered interest rate parity (CIP) is the condition that requires the interest rates to be the same across countries once the exchange rate risk has been hedged away. This idea has been around since at least 1923 when discussed by John Maynard Keynes. Research since then has confirmed that this no-arbitrage condition had been satisfied most of the time before the 2008 Global Financial Crisis. Since the crisis, however, the CIP condition has been persistently violated among G10 currencies, resulting in potentially significant arbitrage opportunities among the largest and most liquid derivative markets in the world.  The violation of CIP creates an interesting puzzle for financial economists and regulators. The authors explore this oddity and find that it is linked to cross-country differences in interest rates and caused, at least partially, by banking regulatory reporting changes. Their findings have implications for the optimal investment of global cash balances, the financing of debt by global firms, and the functioning and regulation of global banks.

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