Seminar 281: International Trade and Finance - Monetary Policy and Covered Interest Rate Parity Deviations: is there a Link?

Seminar | September 11 | 4-5:30 p.m. | 597 Evans Hall

 Ganesh Viswanath Natraj, UC Berkeley

 Department of Economics

Abstract: A fundamental puzzle in international finance is the persistence of covered interest rate parity (CIP) deviations, also referred to as the cross-currency basis. This is indicative of the existence of a dollar financing premium for banks in the Euro area, Japan and Switzerland. Using a model of the microstructure of the foreign exchange swap market, I explore two channels through which the unconventional monetary policies of the European Central Bank, Bank of Japan and Swiss National Bank can create an excess demand for dollar funding. In the first, quantitative easing leads to a relative decline in domestic funding costs, making it cheaper to source dollars via forex swaps. In the second, negative interest rates cause a decline in domestic interest rate margins, as loan rates fall and deposit rates are bound at zero. This induces banks to rebalance their portfolio toward dollar assets, again creating a demand for dollars via forex swaps. Both policies thus lead to an increase in order flow, which is a measure of excess demand for dollars in the forex swap market. Dealers reset the forward price to offset the increase in order flow, and in doing so increase the premium that banks must pay to swap domestic currency into dollars. I show that CIP deviations have tended to widen around negative rate announcements. I similarly document reductions in domestic funding costs, rises in order flow, and a widening of the cross-currency basis following QE announcements.