Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants and Disconnect

Author: Mr. Eugenio M Cerutti and Haonan Zhou

Volume/Issue: Volume 2023 Issue 028

Publication date: February 2023

ISBN: 9798400233166

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Topics covered in this book

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Banks and Banking , Finance , Economics- Macroeconomics , Money and Monetary Policy , Economics / General , Covered interest parity , Interest rate differentials , Forward foreign exchange market , Financial market arbitrage , Emerging markets , CIP deviation , FX Market development , short-term Covered Interest Parity , country default risk , segmented FX markets , Interest rate parity , Currencies , Currency markets , Emerging and frontier financial markets , Forward exchange rates , Global

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Summary

We provide a systematic empirical treatment of short-term Covered Interest Parity (CIP) deviations for a large set of emerging market (EM) currencies. EM CIP deviations have much larger volatilities than most G10 currencies and move in an opposite direction during global risk-off episodes. While off-shore EM CIP deviations are sensitive to changes in FX dealers’ risk-bearing capacities and global risk aversion, on-shore EM CIP deviations are largely unresponsive in segmented FX markets. Moreover, the sensitivity of offshore EM CIP deviations to global risk factors for currencies with segmented FX markets is stronger compared to their counterparts with integrated FX markets. We find weak evidence of country default risk affecting EM CIP deviations after accounting for global factors.