What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia

IMF Working Papers, August 2, 2019

Source details

Canonical URL: What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia

Asian countries have high demand for U.S. dollars and are sensitive to U.S. dollar funding costs.
An important component of U.S. dollar funding costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP).
CIP deviations imply that investors need to pay a premium to borrow U.S. dollars or other currencies on a hedged basis via cross-currency swap markets.
Empirical finding: an increase in the basis spread tightens financial conditions in net debtor countries, while easing financial conditions in net creditor countries.
Main reason for asymmetric effects: net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels.

CIP deviations can be explained by:
- regulatory changes since the global financial crisis, which have limited arbitrage opportunities; and
- country-specific factors that contribute to a mismatch in the demand and supply of U.S. dollars.
Effect on investors: CIP deviations raise the cost of hedged dollar borrowing through cross-currency swaps, thereby affecting funding costs and financial conditions.
Net debtor versus net creditor channels:
- Net debtor countries: higher basis spread → tighter financial conditions, limited substitution to domestic funding.
- Net creditor countries: higher basis spread → easing of financial conditions.

Promote reliable alternative funding sources to reduce vulnerability to U.S. dollar funding stress, including:
- development of long-term corporate bond markets; and
- fostering stable long-term investors.
Consider establishing a “hedging counterpart of last resort” to help stabilize financial intermediation when U.S. dollar funding markets come under stress.

Authors: Gee Hee Hong, Anne Oeking, Kenneth H Kang, Chang Yong Rhee
Publication date: August 2, 2019
Series: IMF Working Papers
Working Paper No.: 2019/169
Volume: 2019
Issue: 169
Pages: 35
DOI: https://doi.org/10.5089/9781513509006.001
ISBN: 9781513509006
ISSN: 1018-5941
Subjects and keywords: Currency markets; External position; Financial crises; Financial markets; Financial regulation and supervision; Financial services; Foreign exchange; Hedging; Interest rate parity; International investment position; Asia and Pacific; Covered interest parity; cross-currency basis; dollar; dollar index; E. U.S. Dollar supply; FX swaps; Global; limits to arbitrage; swap market; U.S. dollar funding; WP

IMF Working Paper — What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia