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

By Gee Hee Hong, Anne Oeking, Kenneth H Kang, Chang Yong Rhee

August 2, 2019

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Gee Hee Hong, Anne Oeking, Kenneth H Kang, and Chang Yong Rhee. What Do Deviations from Covered Interest Parity and Higher FX Hedging Costs Mean for Asia, (USA: International Monetary Fund, 2019) accessed December 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

Asian countries have high demand for U.S. dollars and are sensitive to U.S. dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow U.S. dollars or other currencies on a hedged basis via cross-currency swap markets. These 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. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while easing financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market or stable long-term investors, including a “hedging counterpart of last resort,” can help stabilize financial intermediation when U.S. dollar funding markets come under stress.

Subject: Currency markets, External position, Financial crises, Financial markets, Financial regulation and supervision, Financial services, Foreign exchange, Hedging, Interest rate parity, International investment position

Keywords: Asia and Pacific, Covered interest parity, Cross-currency basis, Currency, Currency markets, Dollar, Dollar index, E. U.S. Dollar supply, FX swaps, Global, Hedging, Interest rate parity, International investment position, Limits to arbitrage, Swap market, U.S. dollar, U.S.dollar funding, WP

Publication Details

Pages:

35
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2019/169
Stock No:

WPIEA2019169
ISBN:

9781513509006
ISSN:

1018-5941

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