Session 2: The role of balance sheet constraints
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1 Session 2: The role of balance sheet constraints Paper 1, by T. IidaT Kimura, and N. Sudo Paper 2, by V. Sushko, C. Borio, R. McCauley, andp. McGuire Discussant: : CIP - RIP? May 2017, BIS, Basel
2 Session 2: The role of balance sheet constraints and much more! Paper 1, by T. IidaT Kimura, and N. Sudo Paper 2, by V. Sushko, C. Borio, R. McCauley, andp. McGuire Discussant: : CIP - RIP? May 2017, BIS, Basel
3 Both papers are Very interesting works! Significant contributions to the theoretical and empirical literature on CIP!
4 Regulatory reforms and the dollar funding of global banks: evidence from the impact of monetary policy divergence T. Iida T Kimura, and N. Sudo
5 Schematic view 1 2 4
6 D/S for USD in swap market Comment 1: Why JP (US) bank bears a credit risk premium p (p*) only on the US (JP) liabilities? Market segmentation? 5
7 D/S for USD in swap market Comment 2: Why only US bank has an endowment (W=0)? JP bank cannot get bankrupt? 6
8 D/S for USD in swap market ; ; ;Δ 7
9 D/S for USD in swap market ; ; ;Δ ; ;Δ; ; 8?
10 Then, CIP deviation depends on Interest margin differential: Default probability JP firm: Default probability arbitrageur: Liquidity needs and endowment: 9
11 Suggestion Elaborate on interest margin differential: Short-term FX carry trade: Long-term FX carry trade: Interest-rate carry trade: Inverted yield curve and nominal negative rates: and / or 10
12 The failure of covered interest parity: FX hedging demand and costly balance sheets V. Sushko, C. Borio, R. McCauley, and P. McGuire 11
13 This paper in a nutshell CIP crucially depends on supply/demand conditions in the markets for currency forwards and swaps Part of the demand is sticky (e.g. institutional, corporates) Taking the other side of net FX hedging imbalances is costly since it entails taking balance sheet exposures to OTC FX derivatives Prudent risk management requires higher capital charges for both credit and market risks in terms of More hedges (e.g. CDS), More collateral and variation margins But also CCP 12
14 Main findings Even small counterparty and market risks of FX swaps give rise to balance sheet costs that make it unprofitable to arbitrage CIP deviation unless these are large enough No-arbitrage bounds increase with the size of the balance sheet exposed to the trade 13
15 Very nice theoretical framework CIP arbitrageurs are averse to the counterparty credit risk and have an exponential utility function over one period and pay the transaction costs (bid, ask) Assume log normality and to get the objective function framed in a certainty equivalent meanvariance setting where the second moment captures the shadow balance-sheet cost Connection to Zigrand, Shin, and Danielsson (2010) s VaR Liquidity constraints increase funding costs Connection Gromb and Vayanos (2010) s limits to arbitrage 14
16 Comments and suggestions Supranational, sovereign agencies, and central bank: the currency basis does really represent a profit opportunity? They might hold a sizable amount of FX reserves but don t act as arbitrageurs Better connection between theory and long-run (risk) and short-run (liquidity) factors Quarterly BIS stats interpolated to get monthly data GC versus Specials USD swap lines 15
17 Main question 16
18 Possible reasons Mismeasurement Transaction costs Funding constraints Aversion to market risk Aversion to credit risk Market segmentation Especially in the new monetary and regulatory regimes Another possible reason: Spoilt for choice 17
19 Spoilt for choice At the same time of the CIP deviations, there have been a number of more attractive investment opportunities, including FX (e.g. triangular), equities (e.g. multiple listings, ADR), bonds, corporate bonds (Liao), repos Exacerbated by distortionary effects and manipulated prices due to monetary policies and new regulations Why not FX carry trade rather than more complex CIP strategies when central banks has removed FX risk? How should an investor / arbitrageur invest his (more) limited own capital? Lexicographical order? Which criterion first? Accessibility? Max profit? Simplicity? 18
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