Deviations from Covered Interest Parity in the Emerging Markets After the 2008 Global Financial Crisis

Deviations from Covered Interest Parity in the Emerging Markets After the 2008 Global Financial Crisis

21/26

English

September  2021

In this paper, we examine deviations from covered interest parity (CIP) for six emerging market economies using daily data following the global financial crisis. After documenting large and persistent discrepancies between January 2010 and July 2018, we show the significant role of local factors in explaining sustained deviations from CIP. Specifically, we present evidence that the main drivers of explaining CIP deviations are cost of illiquidity and interest differentials. Our findings suggest that the impact of credit risk on CIP deviations in emerging market economies may take two forms. In low-carry currencies, the well-known mechanism for credit risk operates so that the increase in credit risk exacerbates CIP deviations. Conversely, in high-carry currencies, the high usage of FX swaps makes swap rates react more than domestic rates, which causes CIP to decrease. Finally, global factors play no prominent role in predicting CIP deviations.

Covered interest parity, FX swap, Emerging markets, Financial crisis

G15; F31