Exchange Rate Determination under Limits to CIP Arbitrage

Philippe Bacchetta, Jonathan Davis and Eric van Wincoop

No 32876, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Recent theories of exchange rate determination have emphasized limited UIP arbitrage by international financial institutions. New regulations since 2008 have also lead 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.

JEL-codes: F30 F31 G15 (search for similar items in EconPapers)
Date: 2024-08
New Economics Papers: this item is included in nep-mon and nep-opm
Note: AP IFM
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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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