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P2.T8.20.17. Covered interest rate parity lost (Borio)

Nicole Seaman

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Learning objectives: Differentiate between the mechanics of foreign exchange (FX) swaps and cross-currency swaps. Identify key factors that affect the cross-currency swap basis. Assess the causes of covered interest rate parity violations after the financial crisis of 2008.

Questions:

20.17.1. Assume the spot foreign exchange (FX) rate between the US dollar and the Japanese Yen is 110.00 which can be represented as USDJPY 110.00 or JPY 110.00 where USD is the base currency and JPY is the quote currency; aka, quote 110.00 yen per one dollar of the base or "per unit" currency. The USD interest rate is 2.50% and the JPY interest rate is 0.450%. The period is one year and the compound frequency is annual. If the covered interest rate (CIP) arbitrage framework enforces a perfectly accurate one-year forward exchange rate, then what is the implied one-year "swap rate" which is here simply defined as the difference between the forward FX rate and the spot FX rate; put simply, what is the difference, F(USDJYP) - S(USDJPY), or F(USDJPY) - 110.00?

a. -2.20 JPY (or -2.20 USDJPY)
b. Zero
c. + 5.80 JPY
d. + 13.70 JPY


20.17.2. In regard to the difference between a foreign exchange (FX) swap and a cross-currency swap, each of the following is true (as a difference) EXCEPT which statement is false?

a. An FX swap is typically a shorter-term instrument while a cross-currency swap is a longer-term instrument (typically above one year)
b. Covered interest rate parity (CIRP) cannot fail (ie, cannot be violated) in the case of an FX swap, while CIRP cannot even be tested on a cross-currency swap because the final exchange uses the initial spot rate
c. At maturity, the FX swap has the counterparties repay the borrowed amounts at the pre-agreed forward rate, but the cross-currency swap exchanges the borrowed amounts as the initial spot rate
d. The FX swap typically has only two cash flow legs (i.e., initially simultaneous lending and then repayment at maturity), but the cross-currency swap exchanges several interim interest payments


20.17.3. Peter is a CFA candidate who has been studying covered interest rate parity (CIRP) but he is also reading that "since the Global Financial Crisis (GFC), CIRP has failed to hold." Peter has assumed CIPR is the closest thing to a physical law in finance. His friend Patricia is an FRM candidate and she offers two explanations for the apparent anomaly:

I. The basis tends to open up because banks, institutional investors, and non-financial firms tend to demand currency hedges; e.g., banks tend to close balance sheet currency mismatches with FX swaps​
II. Academic (examples of) arbitrage tends to ignore frictional costs, but after the GFC participants tend to price the costs and hidden risks of arbitrage; e.g., arbitrage enlarges the balance sheet​

Which statement(s) by Patricia explain the violation(s) of CIRP since the GFC?

a. Neither I. nor II.
b. Only I.
c. Only II.
d. Both I. and II.

Answers here:
 
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