Covered Interest Parity in Emerging Markets: Measurement and Drivers
IMF Working Papers, March 28, 2025
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- Covered Interest Parity in Emerging Markets: Measurement and Drivers
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Bibliographic details
- Authors: Mai Dao, Pierre-Olivier Gourinchas
- Published: March 28, 2025
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798229003995.001
Summary
- Investigates the behavior of Covered Interest Parity (CIP) deviations – aka the CIP basis – in Emerging Markets (EM).
- Identifies a major empirical challenge: measuring local currency interest rates that are free of local credit risk.
- Constructs a “purified” CIP basis for eight major EM currencies using supranational bonds issued in EM local currencies and US dollar going back twenty years.
- Finds that the “purified” CIP basis aligns well with theory-implied predictions.
- Shows that, in both the cross-section and the timeseries, the basis correlates with fundamental forces driving supply and demand for dollar forwards.
Data and Methodology
- Purified CIP basis constructed from supranational bonds issued in EM local currencies and US dollar.
- Sample spans twenty years and covers eight major EM currencies.
- Emphasis on isolating local-currency interest rates free of local credit risk to measure CIP deviations accurately.
Key Findings
- The purified CIP basis is consistent with theoretical predictions for CIP deviations.
- Cross-sectional and time-series variation in the CIP basis is correlated with variables that affect supply and demand for dollar forwards.
Identified Drivers of CIP Deviations in EMs
- Shocks to global dollar funding costs.
- Changes in global intermediaries’ balance sheet capacity.
- Variation in demand for dollar safe assets.
- Currency-specific dollar hedging needs.
- Currency-specific dollar funding needs.
- These global and currency-specific forces interact to move the CIP basis in EMs.
Implications and Relevance
- Accurate measurement of CIP deviations in EMs requires purification of local interest rates from local credit risk.
- Understanding the interaction between global dollar liquidity conditions and currency-specific hedging/funding needs is crucial for interpreting CIP movements in EMs.
- Results are relevant for policymakers and market participants monitoring dollar funding stress and forward market pricing in emerging markets.
Mai Dao and Pierre-Olivier Gourinchas, March 28, 2025
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- Working Paper