Covered interest rate parity violations : can they be anticipated?
Creators: name: Piana, Dominic
Publisher: name: ZHAW Zürcher Hochschule für Angewandte Wissenschaften
Year: 2017
Subjects: 332: Finanzwirtschaft

description: The covered interest rate parity (CIP) condition is widely known and taught in academia. Since the Great Financial Crisis, sustained violations of the CIP condition have occurred, pointing to arbitrage opportunities. Pinnington and Shamloo (2016) investigated these deviations for the foreign currency cross-currency basis (basis) against Swiss franc, with a focus on the first half of 2015.

The objective of this paper consisted of analyzing violations from CIP between January 2011 and December 2016 for the US dollar, Euro and British sterling basis against Swiss franc and whether changes in the basis could have been anticipated with implied FX volatilities. A focus was laid on the negative deviations, signifying that the interest rate earned over the synthetic replication is higher than over the direct investment. Therefore, the cross-currency bases from 4 January to 30 December 2016 for the maturities of one-, two-, three- and six-month were analyzed, which led to a data sample per currency and tenor of n=1515. First of all, the data set was investigated for violations of the CIP condition. As the cross-currency basis was hardly never zero, a CIP trading range of 10 basis points above and 10 basis points below zero was determined to differentiate minor from substantial violations. In a second step, the changes in the basis were scatter plotted against the changes in implied FX volatilities.

The analysis revealed that CIP violations occurred during the covered period. The US dollar cross-currency basis exhibited the most negative CIP violations of all currency bases analyzed. It was found that the Euro bases showed more positive than negative violations, whereas positive and negative violations were approximately balanced for the British sterling. Generally, the shorter the tenor, the more negative deviations were observed. The cross-currency basis tended to decrease one month before the end of the year. This was detected for most tenors and currencies under analysis. The highest R2 observed from the scatter plots stood at 0.0586.

It was concluded that the CIP violations offered substantial arbitrage opportunities. Generally, the cross-currency bases corrected around one month before year-ends and the shorter the tenor, the more pronounced the correction tended to occur. Furthermore, interest rate shocks or sudden changes in central bank policies were followed by a sharp correction of the basis which recovered within one month. Lastly, no evidence was found that changes in bases can be anticipated by changes in implied FX volatility.

Banks and financial institutions with ample balance sheet capacities should investigate if they want to take advantage of CIP violations, as they offer a possibility to increase their profits. With the acceptance of interest rate risk, the profits could be further increased as Swiss banks can borrow foreign currency from their clients and deposit the Swiss francs on the sight deposit at the Swiss National Bank. But before engaging in CIP arbitrage transactions, banks should calculate the resulting capital costs thoroughly, to evaluate whether the risk-free profits outweigh the capital costs involved.