Exchange Rate Determination Under Limits to CIP Arbitrage

Philippe Bacchetta, Jonathan Davis and Eric Van Wincoop

No 425, Globalization Institute Working Papers from Federal Reserve Bank of Dallas

Abstract: Recent theories of exchange rate determination have emphasized limited UIP arbitrage by international financial institutions. New regulations since 2008 have also led 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: U.S. Dollar; exchange rate; CIP deviations (search for similar items in EconPapers)
JEL-codes: F31 G15 (search for similar items in EconPapers)
Pages: 42
Date: 2023-12-15, Revised 2024-09-23
New Economics Papers: this item is included in nep-ban, nep-ifn, nep-mon and nep-opm
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Related works:
Working Paper: Exchange Rate Determination under Limits to CIP Arbitrage (2024)
Working Paper: Exchange Rate Determination under Limits to CIP Arbitrage (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:feddgw:97492

DOI: 10.24149/gwp425r1

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