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

_IMF Working Papers, August 2, 2019_

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## Bibliographic details
- Authors: Gee Hee Hong, Anne Oeking, Kenneth H Kang, Chang Yong Rhee
- Published: August 2, 2019
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513509006.001

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### Overview and main findings
- 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.

### Explanations and mechanisms
- 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.

### Policy implications and recommendations
- 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.

### Publication and metadata
- 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*

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_Source: https://www.imf.org/en/publications/wp/issues/2019/08/02/what-do-deviations-from-covered-interest-parity-and-higher-fx-hedging-costs-mean-for-asia-48531_