Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Covered Interest Parity yet again

I have blogged several times about how Covered Interest Parity (CIP) is not valid in the multi-curve discounting framework that is the standard in finance after the Global Financial Crisis. (My last post a couple of years ago argued that economists who still believe in CIP unreservedly are simply ignoring risk; earlier posts described the cross currency basis and the multi curve discounting framework).

Recently, I read a paper by Wong and Zhang that is perhaps the most lucid explanation that I have seen of the phenomenon of CIP violations and the emergence of a large cross currency basis. They are able to explain not only why the forward premium is not equal to the Libor differential, but also why the CIP violation persists when Libor is replaced by (near) risk free rates like OIS (Overnight Indexed Swaps) or repo.

Wong and Zhang point out that the Libor-OIS spread reflects two different things. First, Libor carries significant counterparty credit risk because it involves unsecured lending for a non trivial time period, while the overnight tenor of OIS reduces the credit risk to negligible levels. Second, Libor carries an exposure to funding liquidity risk because the lender has to fund the loan till maturity, while OIS involves only an exchange of interest cash flows without any principal funding.

The Cross Currency Basis Swap (CCBS) in its post-crisis form does not expose the counterparties to credit risk because of collateralization and variation margins. But it does involve funding liquidity risk (each party receives liquidity in one currency and gives up liquidity in another currency). Thus the CCBS spread reflects only one part of the Libor-OIS spread – the part that accounts for funding liquidity risk. The empirical results in the Wong and Zhang paper show that in some currencies, the Libor-OIS spread is dominated by credit risk while in other currencies (notably the US dollar) it is dominated by funding liquidity risk. As a result, a CIP violation is observed whether one measures the interest differential using Libor or OIS.

Of course, all this is consistent with the multi-curve discounting framework, but this analysis is probably a lot easier to understand.


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