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Uncovering covered interest parity: the role of bank regulation and monetary policy

Falk Bräuning and Kovid Puria ()

No 17-3, Current Policy Perspectives from Federal Reserve Bank of Boston

Abstract: We analyze the factors underlying the recent deviations from covered interest parity. We show that these deviations can be explained by tighter post-crisis bank capital regulations that made the provision of foreign exchange swaps more costly. Moreover, the recent monetary policy and related interest rate divergence between the United States and other major foreign countries has led to a surge in demand for swapping low interest rate currencies into the U.S. dollar. Given the higher bank balance sheet costs resulting from these regulatory changes, the increased demand for U.S. dollars in the swap market could not be supplied at a constant price, thereby amplifying violations of covered interest parity. Furthermore, we show that dollar swap line agreements existing between the Federal Reserve and foreign central banks mitigate pressure in the swap market. However, the current conditions that govern the provision of dollar funding through foreign central banks are not favorable enough to reduce deviations from covered interest parity to zero.

Keywords: covered interest parity; monetary policy; banking (search for similar items in EconPapers)
JEL-codes: E52 F31 G15 G18 G2 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2017-06-01
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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