Covered Interest Parity in Emerging Markets: Measurement and Drivers

Covered Interest Parity in Emerging Markets
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Volume/Issue: Volume 2025 Issue 057
Publication date: March 2025
ISBN: 9798229003995
$20.00
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Topics covered in this book

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Banks and Banking , Finance , Money and Monetary Policy , Covered Interest Parity , intermediation frictions , emerging markets , forward exchange rates , Sovereign bonds , Bonds , Yield curve , Hedging , Spot exchange rates , Interbank rates , Interest rate parity , Emerging and frontier financial markets , Currencies , Currency markets , Global

Summary

We study the behavior of Covered Interest Parity (CIP) deviations – aka the CIP basis - in Emerging Markets (EM). A major challenge in computing the CIP basis in EM’s lies in measuring local currency interest rates which are free of local credit risk. To do so, we construct a ‘purified’ CIP basis for eight major EM currencies using supranational bonds issued in EM local currencies and US dollar going back twenty years. We show that this ‘purified’ CIP basis aligns well with theory-implied predictions. In the cross-section and the timeseries, the basis correlates with fundamental forces driving supply and demand for dollar forwards. Shocks to global dollar funding costs, global intermediary’s balance sheet capacity, and the demand for dollar safe assets interact with currency-specific dollar hedging and funding needs in moving the CIP basis in EM’s.