Post on 24-Sep-2020
CIP deviations during the crisis
Covered interest rate parity deviations during the crisis
Tommaso Mancini Griffoli, Angelo RanaldoSNB research unit
BOP - SNB Joint Conference, Zurich June 15, 2009
1
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
2
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
2
CIP deviations during the crisis
Covered Interest Parity (CIP)
3
i* i
CIP deviations during the crisis
Covered Interest Parity (CIP)
3
i* i
depreciation
CIP deviations during the crisis
Covered Interest Parity (CIP)
3
i* i
depreciation
=
CIP deviations during the crisis
CIP condition
4
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP condition
4
1S
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP condition
4
(1+i*)1S
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP condition
4
(1+i*)SF
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP condition
4
(1+i*) (1+i)=SF
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP condition
4
(1+i*) (1+i)=SF
interest differential
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP condition
4
(1+i*) (1+i)=SF
interest differentialdepreciation(forward premium)
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)>SF
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)>SF
• Riskless gains!• Sell (short) domestic currency spot• Buy (long) domestic currency forward
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)>SF
• Riskless gains!• Sell (short) domestic currency spot• Buy (long) domestic currency forward
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP balancing
5
(1+i*) (1+i)SF
• Riskless gains!• Sell (short) domestic currency spot• Buy (long) domestic currency forward
=
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
In theory...
• CIP should always hold!
• Otherwise, infinite Sharpe ratios!
6
CIP deviations during the crisis
In practice...
• Some deviations in CIP
‣ Over short periods (Taylor ’89)
‣ Over longer periods... since Lehman
- Baba, Packer & Nagano (BIS ’08), Baba & Packer (BIS ’09), Coffey, Hrung, Nguyen & Sarkar (NYFed ’09), others...
7
CIP deviations during the crisis
CIP deviations
8
Returns, long EURCHF, Libor no tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
CIP deviations during the crisis
The story is more complicated!
9
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
10
CIP deviations during the crisis
Problems with using Libor• Ask
• Indicative
• Not representative
• Strategic
• Poor timing
• May not have been used by speculators!
11
CIP deviations during the crisis
A more realistic rate...another funding market
• Bid-Ask spreads
• Traded/ firm prices
• Continuous quotes
• Avoid counterparty risk
• Avoid low liquidity
12
CIP deviations during the crisis
A more realistic rate...another funding market
• Bid-Ask spreads
• Traded/ firm prices
• Continuous quotes
• Avoid counterparty risk
• Avoid low liquidity
12
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√√
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√√√
CIP deviations during the crisis
Overnight rates
Bid-Ask spreads
Traded/ firm prices
Continuous quotes
Avoid counterparty risk
Avoid low liquidity
13
√√√√√
CIP deviations during the crisis
Arbitrage mechanics
14
CIP deviations during the crisis
Arbitrage mechanics
14
Long i
Short j
SPOT
CIP deviations during the crisis
Arbitrage mechanics
14
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
OIS j
CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
OIS j
OIS i
CIP deviations during the crisis
Arbitrage mechanics
14
get O/N i
get O/N i
get O/N i
pay O/N j
pay O/N j
pay O/N j Long j
Short i
FORWARD
Long i
Short j
SPOT
pay O/N j
get O/N i
FUNDING
OIS j
OIS i
(bid j)
(ask i) (bid i)
(ask j)
CIP deviations during the crisis
CIP balancing
15
(1+i*) (1+i)=SF
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP balancing
15
(1+i*) (1+i)=SF
Note: S is domestic per foreign currency units.
CIP deviations during the crisis
CIP condition
16
(1+OIS*B) (1+OISA)=SA
FB
Note: S is domestic per foreign currency units, conventionally referred to as foreign-domestic exchange rate. Buying foreign currency spot is equivalent to emitting a bid for the foreign-domesic rate, thus buying at the market’s ask price, as in SA in the denominator.
CIP deviations during the crisis
CIP profits
17
(1+OIS*B) (1+OISA)_SA
FB
Note: S is domestic per foreign currency units, conventionally referred to as foreign-domestic exchange rate. Buying foreign currency spot is equivalent to emitting a bid for the foreign-domesic rate, thus buying at the market’s ask price, as in SA in the denominator.
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
18
CIP deviations during the crisis
Libor (no transaction costs)
19
Returns, long EURCHF, Libor no tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
CIP deviations during the crisis
OIS (no trans costs)
20
Returns… + OIS no tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tcRet long OISEur no tc
CIP deviations during the crisis
OIS (with trans costs)
21
Returns… + OIS with tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tc
Ret long OISEur no tc
Ret long OISEur w/ tc, w/t fxtc
CIP deviations during the crisis
FX (with trans costs)
22
Returns… + FX with tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tcRet long OISEur no tcRet long OISEur w/ tc, w/t fxtcRet long Eur
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
23
CIP deviations during the crisis
Libor OIS
• Profits change... get rid of default risk
‣ if Libor-OIS spreads higher in target currency
- profits decrease
‣ if Libor-OIS spreads higher in funding currency
- profits increase
24
CIP deviations during the crisis
Libor OIS
25
= α + β (Libor-OIS related variable) + ...CIP profits(Libor, no tc)
CIP deviations during the crisis
Libor OIS
• β will turn out significant
• Tell stories about national vs. foreign default risk
• But uninformative!
25
= α + β (Libor-OIS related variable) + ...CIP profits(Libor, no tc)
CIP deviations during the crisis
Other remarks
• OIS transaction costs hardly affect profits
• FX transaction costs make a significant difference
• Similar results for other currency pairs
26
CIP deviations during the crisis
Main message
• Using more detailed and realistic measures:
‣ Fewer, lower & less persistent CIP deviations
‣ But deviations remain!
‣ Despite our “stricter” test
27
CIP deviations during the crisis
Main message
• Using more detailed and realistic measures:
‣ Fewer, lower & less persistent CIP deviations
‣ But deviations remain!
‣ Despite our “stricter” test
27
We must look further... perhaps at currencies themselves
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
28
CIP deviations during the crisis
Long USD positions
29
Returns, short EURUSD (%)
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
1/1/
001/
25/0
02/
18/0
03/
13/0
04/
6/00
4/30
/00
5/24
/00
6/17
/00
7/11
/00
8/4/
008/
28/0
09/
21/0
010
/15/
0011
/8/0
012
/2/0
012
/26/
001/
19/0
12/
12/0
13/
8/01
4/1/
014/
25/0
15/
19/0
16/
12/0
17/
6/01
7/30
/01
8/23
/01
9/16
/01
10/1
0/01
11/3
/01
11/2
7/01
12/2
1/01
1/14
/02
2/7/
023/
3/02
3/27
/02
CIP deviations during the crisis
Short USD positions
30
Returns, long EURUSD (%)
-0.1
0
0.1
0.2
0.3
0.4
0.5
1/1/
001/
25/0
02/
18/0
03/
13/0
04/
6/00
4/30
/00
5/24
/00
6/17
/00
7/11
/00
8/4/
008/
28/0
09/
21/0
010
/15/
0011
/8/0
012
/2/0
012
/26/
001/
19/0
12/
12/0
13/
8/01
4/1/
014/
25/0
15/
19/0
16/
12/0
17/
6/01
7/30
/01
8/23
/01
9/16
/01
10/1
0/01
11/3
/01
11/2
7/01
12/2
1/01
1/14
/02
2/7/
023/
3/02
3/27
/02
CIP deviations during the crisis
Further clues• Very similar charts for other currency pairs
‣ long dollar (–) profits
‣ short dollar (+) profits
• CIP deviations seem to be
‣ currency specific (dollar)
‣ directional (short dollar)
31
CIP deviations during the crisis
Agenda• CIP basics and motivation
• CIP details
• CIP initial empirics
• Some takeaways
• More empirics
• A theory of CIP breakdown
32
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
CIP deviations during the crisis
Short USD profitable
33
(1+OISEUR) (1+OISUSD)>SA
FB
• FB too high• USD too cheap on FWD market
CIP deviations during the crisis
Towards a theory• FWD not priced according to CIP
• Usually, price pressure on FWD comes from arbitrageurs,
• Who short an appreciating currency (for given OIS differential)
• But if - for some reason - arbitrage is insufficient, FWD becomes “stale” (as seen from CIP)
• Thus, spot movements determine if CIP profits are positive or negative
34
CIP deviations during the crisis
An illustration
35
CIP deviations during the crisis
An illustration
35
EURUSD
t
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forward
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forwardCIP i-rate diff
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forwardCIP i-rate diff
forwardCIP i-rate diff
“excess” USD depreciation; CIP breakdown
forward
CIP deviations during the crisis
An illustration
35
Investors
Speculators
EURUSD
t
spot
forwardCIP i-rate diff
forwardCIP i-rate diff
“excess” USD depreciation; CIP breakdown
forward
CIP deviations during the crisis
The short USD experience• Enormous pressure to obtain USD spot USD
appreciation
• Speculators should have shorted USD
• But... insufficient USD available to borrow
• Thus insufficient pressure on USD forward
• Resulting in “excess” USD future depreciation inducing positive CIP profits
36
CIP deviations during the crisis
The short USD experience• Enormous pressure to obtain USD spot USD
appreciation
• Speculators should have shorted USD
• But... insufficient USD available to borrow
• Thus insufficient pressure on USD forward
• Resulting in “excess” USD future depreciation inducing positive CIP profits
36
• No notion of risk!• A funding liquidity constraint!
CIP deviations during the crisis
Long USD unprofitable, same story from flip side
• Positive profits with short USD position
• Negative profits with long USD position
• Except if bid-ask spreads are particularly high relative to profits
37
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
BAS FWD
BAS spot
Balance sheet
TED
Funding liquidity
constraint
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
BAS FWD
BAS spot
Balance sheet
TED
Funding liquidity
constraint
VIX/ CDSRisk
CIP deviations during the crisis
Regressions support our story
38
Long USD Short USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
BAS FWD
BAS spot
Balance sheet
TED
Funding liquidity
constraint
VIX/ CDSRisk
– ++ –+ –– +no no
CIP deviations during the crisis
– – 5.7 ***+ 4.9 ***+ 4.4 ***– – 1.7 ***no not signft
Regressions support our story
39
Long USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
CIP deviations during the crisis
– – 5.7 ***+ 4.9 ***+ 4.4 ***– – 1.7 ***no not signft
Regressions support our story
39
Long USDBAS fwdBAS spot
Balance sheetTED
VIX/ CDS
√√√√√
CIP deviations during the crisis
Summary• CIP deviations, can you believe it?
• CIP arbitrage is complex,
• Literature is too superficial
• Our measure excludes default risk and includes transaction costs (& other benefits)
• But still, deviations exist, although smaller, less frequent and persistent
40
CIP deviations during the crisis
Summary• Study across various currency pairs reveals
‣ short USD positions profitable
• A theory: funding liquidity constraints limit arbitrage
‣ forward price is stale and spot deviations determine CIP arbitrage profitability
• Supported by evidence & regression analysis
41
CIP deviations during the crisis
Summary
• More perspective:
‣ find limits to theoretical zero-risk arbitrage conditions at heart of finance,
‣ more concretely, find which currencies were in excessive demand due to technical reasons during the crisis... USD and CHF
42
CIP deviations during the crisis
Appendix
43
CIP deviations during the crisis
CHF story similar to above
• Great pressure to obtain CHF
• Spot CHF appreciation but limited short CHF speculation (funding liquidity constraint),
• Leaving CHF “too cheap” on fwd market,
• Thus offering profitable short CHF arbitrage
44
CIP deviations during the crisis
CHF story similar to above
• ... as seen in Libor CIP measure,
• but not with our measure due to significant increase in transaction costs
45
Returns… + FX with tc (%)
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
12/4
/06
2/4/
07
4/4/
07
6/4/
07
8/4/
07
10/4
/07
12/4
/07
2/4/
08
4/4/
08
6/4/
08
8/4/
08
10/4
/08
12/4
/08
2/4/
09
4/4/
09
Ret long LiborEur w/t tcRet long Eur
CIP deviations during the crisis
USDEUR, Libor and Net
46
Returns, long EURUSD (%)
-0.1
0
0.1
0.2
0.3
0.4
0.5
3/1/
06
5/1/
06
7/1/
06
9/1/
06
11/1
/06
1/1/
07
3/1/
07
5/1/
07
7/1/
07
9/1/
07
11/1
/07
1/1/
08
3/1/
08
5/1/
08
7/1/
08
9/1/
08
11/1
/08
1/1/
09
3/1/
09
Libor, no trans costs
OIS & FX with transcosts