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Evaluate the reasons that covered interest rate parity stopped holding in the wake of the 2008 financial crisis.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Covered Interest Parity Lost: Understanding the Cross-Currency Basis · FRM2.LTR.16.c

The idea

Covered interest parity says a currency's forward premium offsets the interest rate differential, so hedged borrowing or lending costs the same in either currency and the cross-currency basis is zero. It held tightly before 2007 because arbitrageurs, mainly large banks, could borrow in the cheap currency, swap and lend in the dear one for a riskless profit that exceeded their cost. In the 2007 to 2009 crisis, credit risk and dollar funding shortages opened the gap temporarily. It then stayed open because post-crisis rules made the trade costly. Leverage ratios charge for gross derivative and repo exposures whatever the risk, capital and liquidity requirements raised the price of balance sheet, and bank credit spreads rose. The return from closing the gap is measured against capital, not the exposure. Strong demand from policy divergence also kept the basis wide. Exam point: the arbitrage still exists, but it is no longer riskless profit once the cost of scarce balance sheet is counted.

Formulas

Covered interest parity forward rate

F = S × (1 + r(USD) × t) ÷ (1 + r(EUR) × t)

S
the spot rate, in USD per EUR
r(USD)
the dollar interest rate, annualised simple
r(EUR)
the euro interest rate, annualised simple
t
the period, in years

If the market forward differs, a covered arbitrage appears. Since the crisis it persists, because the arbitrage uses costly balance sheet.

Return on capital from a basis arbitrage

Return on capital = Basis ÷ k

Basis
the size of the cross-currency basis, earned on each unit of exposure
k
the capital required per unit of exposure, such as a leverage ratio

Measured against capital, not exposure. When the return falls short of the hurdle rate the basis stays open.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which statement describes covered interest parity (CIP)?

  1. The expected future spot rate equals the forward rate, so unhedged returns are equalized across currencies.Why not: Describes uncovered interest parity and the forward unbiasedness idea, which involve expectations and no hedging.
  2. Interest rates in two currencies are equal after adjusting for inflation differentials in each country.Why not: Describes real interest rate equality, which concerns inflation and not a covered arbitrage with the forward.
  3. The forward premium offsets the interest differential, so hedged funding costs the same in either currency. - correct
  4. The spot exchange rate equals the ratio of the price levels in the two countries, goods basket by basket.Why not: Describes purchasing power parity, which is a goods-price relation, not a covered interest relation.

CIP says F/S = (1 + r_domestic) / (1 + r_foreign) for the same tenor. If it fails, a riskless covered arbitrage appears. The cross-currency basis is the measured deviation from this relation.

A harder one

Which factor explains the sharp widening of the basis in late 2008 but is NOT needed to explain why the basis stayed open after 2010?

  1. Regulatory leverage ratios charging for gross derivative exposures.Why not: Post-crisis rules explain the persistence after 2010 and so are required for the later period.
  2. Acute counterparty credit worries and a shortage of dollar funding among banks. - correct
  3. Divergent monetary policy between the Fed and other central banks.Why not: Policy divergence became prominent in 2014 and later, so it is a later-period driver.
  4. Strong foreign investor demand to hedge dollar asset purchases.Why not: A structural demand that persisted after the crisis and so helps explain the later period.

The 2008 spike was dominated by bank credit risk and the freezing of dollar funding markets, which eased as central banks provided dollar liquidity. Regulation, hedging demand and policy divergence kept the basis open afterwards.

The hardest tier

EUR/USD spot is 1.1000 and the 3-month forward is 1.1040. The 3-month EUR deposit rate is 2.00% and the 3-month USD borrowing rate is 3.00%, both annualized simple. An arbitrageur borrows USD 100 million, converts to EUR at spot, deposits, and sells the EUR proceeds forward. Ignoring costs, which is the profit at maturity?

  1. About USD 386 thousand lossWhy not: Omits the EUR deposit interest, so the forward sale covers only the principal.
  2. About USD 865 thousandWhy not: Omits the interest owed on the USD borrowing and counts the gross maturity value as profit.
  3. About USD 115 thousand - correct
  4. About USD 250 thousand lossWhy not: Converts the maturity proceeds at the spot rate instead of the forward rate, as if the position were unhedged.

EUR bought = 100 / 1.1000 = 90.909 million. After interest 90.909 x 1.005 = 91.364 million EUR. Sold forward at 1.1040 gives USD 100.866 million. Repay 100 x 1.0075 = 100.75 million. Profit = USD 0.115 million. The covered-parity forward would be 1.1027, so the forward is too high.

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