{
  "title": "Covered Interest Parity in Emerging Markets: Measurement and Drivers",
  "publication": "IMF Working Papers, March 28, 2025",
  "sourceUrl": "https://www.imf.org/en/publications/wp/issues/2025/03/24/covered-interest-parity-in-emerging-markets-measurement-and-drivers-565306",
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  "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.",
  "sections": [
    {
      "heading": "Summary",
      "content": "- Investigates the behavior of Covered Interest Parity (CIP) deviations – aka the CIP basis – in Emerging Markets (EM).\n- Identifies a major empirical challenge: measuring local currency interest rates that are free of local credit risk.\n- 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.\n- Finds that the “purified” CIP basis aligns well with theory-implied predictions.\n- Shows that, in both the cross-section and the timeseries, the basis correlates with fundamental forces driving supply and demand for dollar forwards."
    },
    {
      "heading": "Data and Methodology",
      "content": "- Purified CIP basis constructed from supranational bonds issued in EM local currencies and US dollar.\n- Sample spans twenty years and covers eight major EM currencies.\n- Emphasis on isolating local-currency interest rates free of local credit risk to measure CIP deviations accurately."
    },
    {
      "heading": "Key Findings",
      "content": "- The purified CIP basis is consistent with theoretical predictions for CIP deviations.\n- Cross-sectional and time-series variation in the CIP basis is correlated with variables that affect supply and demand for dollar forwards."
    },
    {
      "heading": "Identified Drivers of CIP Deviations in EMs",
      "content": "- Shocks to global dollar funding costs.\n- Changes in global intermediaries’ balance sheet capacity.\n- Variation in demand for dollar safe assets.\n- Currency-specific dollar hedging needs.\n- Currency-specific dollar funding needs.\n- These global and currency-specific forces interact to move the CIP basis in EMs."
    },
    {
      "heading": "Implications and Relevance",
      "content": "- Accurate measurement of CIP deviations in EMs requires purification of local interest rates from local credit risk.\n- Understanding the interaction between global dollar liquidity conditions and currency-specific hedging/funding needs is crucial for interpreting CIP movements in EMs.\n- Results are relevant for policymakers and market participants monitoring dollar funding stress and forward market pricing in emerging markets.\n\nMai Dao and Pierre-Olivier Gourinchas, March 28, 2025\n\n---\n\n Content in this bundle\n\n- Working Paper\n  - Working Paper (Markdown version){rel=\"alternate\" type=\"text/markdown\"}\n  - Working Paper (PDF){rel=\"external\" type=\"application/pdf\"}\n\n---\n\nSource: https://www.imf.org/en/publications/wp/issues/2025/03/24/covered-interest-parity-in-emerging-markets-measurement-and-drivers-565306"
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    "Authors: Mai Dao, Pierre-Olivier Gourinchas",
    "Published: March 28, 2025",
    "Series: IMF Working Papers",
    "DOI: https://doi.org/10.5089/9798229003995.001",
    "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.",
    "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.",
    "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.",
    "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.",
    "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.",
    "**Working Paper**"
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