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CIP deviations during the crisis
Covered interest rate parity deviations during the crisis
Tommaso Mancini Griffoli, Angelo RanaldoSNB research unit
BOP - SNB Joint Conference, Zurich June 15, 2009
1
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CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
2
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CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
2
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CIP deviations during the crisis
Covered Interest Parity (CIP)
3
i* i
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CIP deviations during the crisis
Covered Interest Parity (CIP)
3
i* i
depreciation
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CIP deviations during the crisis
Covered Interest Parity (CIP)
3
i* i
depreciation
=
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CIP deviations during the crisis
CIP condition
4
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP condition
4
1S
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP condition
4
(1+i*)1S
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP condition
4
(1+i*)SF
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP condition
4
(1+i*) (1+i)=SF
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP condition
4
(1+i*) (1+i)=SF
interest differential
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP condition
4
(1+i*) (1+i)=SF
interest differentialdepreciation(forward premium)
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)>SF
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)>SF
• Riskless gains!• Sell (short) domestic currency spot• Buy (long) domestic currency forward
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)>SF
• Riskless gains!• Sell (short) domestic currency spot• Buy (long) domestic currency forward
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)SF
• Riskless gains!• Sell (short) domestic currency spot• Buy (long) domestic currency forward
=
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
In theory...
• CIP should always hold!
• Otherwise, infinite Sharpe ratios!
6
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CIP deviations during the crisis
In practice...
• Some deviations in CIP
‣ Over short periods (Taylor ’89)
‣ Over longer periods... since Lehman
- Baba, Packer & Nagano (BIS ’08), Baba & Packer (BIS ’09), Coffey, Hrung, Nguyen & Sarkar (NYFed ’09), others...
7
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CIP deviations during the crisis
CIP deviations
8
Returns, long EURCHF, Libor no tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
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CIP deviations during the crisis
The story is more complicated!
9
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CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
10
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CIP deviations during the crisis
Problems with using Libor• Ask
• Indicative
• Not representative
• Strategic
• Poor timing
• May not have been used by speculators!
11
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CIP deviations during the crisis
A more realistic rate...another funding market
• Bid-Ask spreads
• Traded/ firm prices
• Continuous quotes
• Avoid counterparty risk
• Avoid low liquidity
12
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CIP deviations during the crisis
A more realistic rate...another funding market
• Bid-Ask spreads
• Traded/ firm prices
• Continuous quotes
• Avoid counterparty risk
• Avoid low liquidity
12
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CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
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CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√
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CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√
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CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√√
![Page 30: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/30.jpg)
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√√√
![Page 31: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/31.jpg)
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√√√√
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CIP deviations during the crisis
Arbitrage mechanics
14
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CIP deviations during the crisis
Arbitrage mechanics
14
Long i
Short j
SPOT
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CIP deviations during the crisis
Arbitrage mechanics
14
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
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CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
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CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
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CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
OIS j
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CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
OIS j
OIS i
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CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
OIS j
OIS i
(bid j)
(ask i) (bid i)
(ask j)
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CIP deviations during the crisis
CIP balancing
15
(1+i*) (1+i)=SF
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP balancing
15
(1+i*) (1+i)=SF
Note: S is domestic per foreign currency units.
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CIP deviations during the crisis
CIP condition
16
(1+OIS*B) (1+OISA)=SA
FB
Note: S is domestic per foreign currency units, conventionally referred to as foreign-domestic exchange rate. Buying foreign currency spot is equivalent to emitting a bid for the foreign-domesic rate, thus buying at the market’s ask price, as in SA in the denominator.
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CIP deviations during the crisis
CIP profits
17
(1+OIS*B) (1+OISA)_SA
FB
Note: S is domestic per foreign currency units, conventionally referred to as foreign-domestic exchange rate. Buying foreign currency spot is equivalent to emitting a bid for the foreign-domesic rate, thus buying at the market’s ask price, as in SA in the denominator.
![Page 44: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/44.jpg)
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
18
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CIP deviations during the crisis
Libor (no transaction costs)
19
Returns, long EURCHF, Libor no tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
![Page 46: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/46.jpg)
CIP deviations during the crisis
OIS (no trans costs)
20
Returns… + OIS no tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tcRet long OISEur no tc
![Page 47: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/47.jpg)
CIP deviations during the crisis
OIS (with trans costs)
21
Returns… + OIS with tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tc
Ret long OISEur no tc
Ret long OISEur w/ tc, w/t fxtc
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CIP deviations during the crisis
FX (with trans costs)
22
Returns… + FX with tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tcRet long OISEur no tcRet long OISEur w/ tc, w/t fxtcRet long Eur
![Page 49: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/49.jpg)
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
23
![Page 50: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/50.jpg)
CIP deviations during the crisis
Libor OIS
• Profits change... get rid of default risk
‣ if Libor-OIS spreads higher in target currency
- profits decrease
‣ if Libor-OIS spreads higher in funding currency
- profits increase
24
![Page 51: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/51.jpg)
CIP deviations during the crisis
Libor OIS
25
= α + β (Libor-OIS related variable) + ...CIP profits(Libor, no tc)
![Page 52: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/52.jpg)
CIP deviations during the crisis
Libor OIS
• β will turn out significant
• Tell stories about national vs. foreign default risk
• But uninformative!
25
= α + β (Libor-OIS related variable) + ...CIP profits(Libor, no tc)
![Page 53: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/53.jpg)
CIP deviations during the crisis
Other remarks
• OIS transaction costs hardly affect profits
• FX transaction costs make a significant difference
• Similar results for other currency pairs
26
![Page 54: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/54.jpg)
CIP deviations during the crisis
Main message
• Using more detailed and realistic measures:
‣ Fewer, lower & less persistent CIP deviations
‣ But deviations remain!
‣ Despite our “stricter” test
27
![Page 55: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/55.jpg)
CIP deviations during the crisis
Main message
• Using more detailed and realistic measures:
‣ Fewer, lower & less persistent CIP deviations
‣ But deviations remain!
‣ Despite our “stricter” test
27
We must look further... perhaps at currencies themselves
![Page 56: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/56.jpg)
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
28
![Page 57: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/57.jpg)
CIP deviations during the crisis
Long USD positions
29
Returns, short EURUSD (%)
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
1/1/
001/
25/0
02/
18/0
03/
13/0
04/
6/00
4/30
/00
5/24
/00
6/17
/00
7/11
/00
8/4/
008/
28/0
09/
21/0
010
/15/
0011
/8/0
012
/2/0
012
/26/
001/
19/0
12/
12/0
13/
8/01
4/1/
014/
25/0
15/
19/0
16/
12/0
17/
6/01
7/30
/01
8/23
/01
9/16
/01
10/1
0/01
11/3
/01
11/2
7/01
12/2
1/01
1/14
/02
2/7/
023/
3/02
3/27
/02
![Page 58: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/58.jpg)
CIP deviations during the crisis
Short USD positions
30
Returns, long EURUSD (%)
-0.1
0
0.1
0.2
0.3
0.4
0.5
1/1/
001/
25/0
02/
18/0
03/
13/0
04/
6/00
4/30
/00
5/24
/00
6/17
/00
7/11
/00
8/4/
008/
28/0
09/
21/0
010
/15/
0011
/8/0
012
/2/0
012
/26/
001/
19/0
12/
12/0
13/
8/01
4/1/
014/
25/0
15/
19/0
16/
12/0
17/
6/01
7/30
/01
8/23
/01
9/16
/01
10/1
0/01
11/3
/01
11/2
7/01
12/2
1/01
1/14
/02
2/7/
023/
3/02
3/27
/02
![Page 59: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/59.jpg)
CIP deviations during the crisis
Further clues• Very similar charts for other currency pairs
‣ long dollar (–) profits
‣ short dollar (+) profits
• CIP deviations seem to be
‣ currency specific (dollar)
‣ directional (short dollar)
31
![Page 60: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/60.jpg)
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
32
![Page 61: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/61.jpg)
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
![Page 62: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/62.jpg)
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
![Page 63: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/63.jpg)
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
![Page 64: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/64.jpg)
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
![Page 65: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/65.jpg)
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
• FB too high• USD too cheap on FWD market
![Page 66: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/66.jpg)
CIP deviations during the crisis
Towards a theory• FWD not priced according to CIP
• Usually, price pressure on FWD comes from arbitrageurs,
• Who short an appreciating currency (for given OIS differential)
• But if - for some reason - arbitrage is insufficient, FWD becomes “stale” (as seen from CIP)
• Thus, spot movements determine if CIP profits are positive or negative
34
![Page 67: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/67.jpg)
CIP deviations during the crisis
An illustration
35
![Page 68: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/68.jpg)
CIP deviations during the crisis
An illustration
35
EURUSD
t
![Page 69: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/69.jpg)
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
![Page 70: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/70.jpg)
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
![Page 71: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/71.jpg)
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forward
![Page 72: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/72.jpg)
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forwardCIP i-rate diff
![Page 73: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/73.jpg)
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forwardCIP i-rate diff
forwardCIP i-rate diff
“excess” USD depreciation; CIP breakdown
forward
![Page 74: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/74.jpg)
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forwardCIP i-rate diff
forwardCIP i-rate diff
“excess” USD depreciation; CIP breakdown
forward
![Page 75: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/75.jpg)
CIP deviations during the crisis
The short USD experience• Enormous pressure to obtain USD spot USD
appreciation
• Speculators should have shorted USD
• But... insufficient USD available to borrow
• Thus insufficient pressure on USD forward
• Resulting in “excess” USD future depreciation inducing positive CIP profits
36
![Page 76: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/76.jpg)
CIP deviations during the crisis
The short USD experience• Enormous pressure to obtain USD spot USD
appreciation
• Speculators should have shorted USD
• But... insufficient USD available to borrow
• Thus insufficient pressure on USD forward
• Resulting in “excess” USD future depreciation inducing positive CIP profits
36
• No notion of risk!• A funding liquidity constraint!
![Page 77: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/77.jpg)
CIP deviations during the crisis
Long USD unprofitable, same story from flip side
• Positive profits with short USD position
• Negative profits with long USD position
• Except if bid-ask spreads are particularly high relative to profits
37
![Page 78: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/78.jpg)
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
![Page 79: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/79.jpg)
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
BAS FWD
BAS spot
Balance sheet
TED
Funding liquidity
constraint
![Page 80: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/80.jpg)
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
BAS FWD
BAS spot
Balance sheet
TED
Funding liquidity
constraint
VIX/ CDSRisk
![Page 81: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/81.jpg)
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
BAS FWD
BAS spot
Balance sheet
TED
Funding liquidity
constraint
VIX/ CDSRisk
– ++ –+ –– +no no
![Page 82: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/82.jpg)
CIP deviations during the crisis
– – 5.7 ***+ 4.9 ***+ 4.4 ***– – 1.7 ***no not signft
Regressions support our story
39
Long USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
![Page 83: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/83.jpg)
CIP deviations during the crisis
– – 5.7 ***+ 4.9 ***+ 4.4 ***– – 1.7 ***no not signft
Regressions support our story
39
Long USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
√√√√√
![Page 84: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/84.jpg)
CIP deviations during the crisis
Summary• CIP deviations, can you believe it?
• CIP arbitrage is complex,
• Literature is too superficial
• Our measure excludes default risk and includes transaction costs (& other benefits)
• But still, deviations exist, although smaller, less frequent and persistent
40
![Page 85: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/85.jpg)
CIP deviations during the crisis
Summary• Study across various currency pairs reveals
‣ short USD positions profitable
• A theory: funding liquidity constraints limit arbitrage
‣ forward price is stale and spot deviations determine CIP arbitrage profitability
• Supported by evidence & regression analysis
41
![Page 86: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/86.jpg)
CIP deviations during the crisis
Summary
• More perspective:
‣ find limits to theoretical zero-risk arbitrage conditions at heart of finance,
‣ more concretely, find which currencies were in excessive demand due to technical reasons during the crisis... USD and CHF
42
![Page 87: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/87.jpg)
CIP deviations during the crisis
Appendix
43
![Page 88: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/88.jpg)
CIP deviations during the crisis
CHF story similar to above
• Great pressure to obtain CHF
• Spot CHF appreciation but limited short CHF speculation (funding liquidity constraint),
• Leaving CHF “too cheap” on fwd market,
• Thus offering profitable short CHF arbitrage
44
![Page 89: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/89.jpg)
CIP deviations during the crisis
CHF story similar to above
• ... as seen in Libor CIP measure,
• but not with our measure due to significant increase in transaction costs
45
Returns… + FX with tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tcRet long Eur
![Page 90: Presenation: Covered interest rate parity deviations during the crisis · CIP deviations during the crisis CIP condition 16 (1+OIS*B) = (1+OISA) SA FB Note: S is domestic per foreign](https://reader036.vdocuments.site/reader036/viewer/2022062606/60098b383ddccc05e411d92b/html5/thumbnails/90.jpg)
CIP deviations during the crisis
USDEUR, Libor and Net
46
Returns, long EURUSD (%)
-0.1
0
0.1
0.2
0.3
0.4
0.5
3/1/
06
5/1/
06
7/1/
06
9/1/
06
11/1
/06
1/1/
07
3/1/
07
5/1/
07
7/1/
07
9/1/
07
11/1
/07
1/1/
08
3/1/
08
5/1/
08
7/1/
08
9/1/
08
11/1
/08
1/1/
09
3/1/
09
Libor, no trans costs
OIS & FX with transcosts