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Risk-adjusted Covered Interest Parity: Theory and Evidence

Alfred Wong, David Leung and Calvin Ng
Additional contact information
Alfred Wong: Hong Kong Monetary Authority
David Leung: Hong Kong Monetary Authority
Calvin Ng: Hong Kong Monetary Authority

No 162016, Working Papers from Hong Kong Institute for Monetary Research

Abstract: We extend the theory of covered interest parity (CIP), aligning the different risks involved in uncollateralized money market transactions and collateralized foreign exchange (FX) swap transactions, which underscore CIP deviations in times of elevated uncertainty. We postulate that the swap dealer behaves as if he tries to filter out the counterparty risk embedded in money market rates in pricing FX swaps. Our results suggest that he does so not only during turbulent times but also under normal market conditions. The extended theory also uncovers a simple way to disentangle counterparty and liquidity risk premiums embedded in money market rates.

Keywords: Covered interest parity; CIP deviation; forward rate; exchange rate; Libor-OIS spread; counterparty credit risk; funding liquidity risk; FX swap (search for similar items in EconPapers)
JEL-codes: F31 F32 G15 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2016-08
New Economics Papers: this item is included in nep-mon
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