Exchange Rate Determination under Limits to CIP Arbitrage

Philippe Bacchetta, Jonathan Davis and Eric van Wincoop

No 18648, CEPR Discussion Papers from Centre for Economic Policy Research

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.

Date: 2023-12
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Working Paper: Exchange Rate Determination under Limits to CIP Arbitrage (2024)
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