Covered interest rate parity deviations during the crisis

Covered interest rate parity deviations during the crisis Tommaso Mancini Griffoli, Angelo Ranaldo SNB research unit BOP - SNB Joint Conference, Zurich June 15, 2009 1

Agenda CIP basics and motivation CIP details CIP initial empirics Some takeaways More empirics A theory of CIP breakdown 2

Covered Interest Parity (CIP) i* i 3

Covered Interest Parity (CIP) depreciation i* i 3

Covered Interest Parity (CIP) depreciation i* = i 3

CIP condition Note: S is domestic per foreign currency units. 4

CIP condition 1 S Note: S is domestic per foreign currency units. 4

CIP condition 1 (1+i*) S Note: S is domestic per foreign currency units. 4

CIP condition F (1+i*) S Note: S is domestic per foreign currency units. 4

CIP condition F (1+i*) = (1+i) S Note: S is domestic per foreign currency units. 4

CIP condition F (1+i*) = (1+i) S interest differential Note: S is domestic per foreign currency units. 4

CIP condition F (1+i*) = (1+i) S depreciation interest differential (forward premium) Note: S is domestic per foreign currency units. 4

CIP balancing F (1+i*) > (1+i) S Note: S is domestic per foreign currency units. 5

CIP balancing F (1+i*) > (1+i) S Riskless gains! Sell (short) domestic currency spot Buy (long) domestic currency forward Note: S is domestic per foreign currency units. 5

CIP balancing F (1+i*) = (1+i) S Riskless gains! Sell (short) domestic currency spot Buy (long) domestic currency forward Note: S is domestic per foreign currency units. 5

In theory... CIP should always hold! Otherwise, infinite Sharpe ratios! 6

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 0.15 Returns, long EURCHF, Libor no tc (% 0.1 0.05 0-0.05 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 4/4/09-0.1-0.15-0.2 8

The story is more complicated! 9

Agenda CIP basics and motivation CIP details CIP initial empirics Some takeaways More empirics A theory of CIP breakdown 10

Problems with using Libor Ask Indicative Not representative Strategic Poor timing May not have been used by speculators! 11

A more realistic rate... another funding market Bid-Ask spreads Traded/ firm prices Continuous quotes Avoid counterparty risk Avoid low liquidity 12

Overnight rates Bid-Ask spreads Traded/ firm prices Continuous quotes Avoid counterparty risk Avoid low liquidity 13

Arbitrage mechanics 14

Arbitrage mechanics SPOT Short j Long i 14

Arbitrage mechanics SPOT FUNDING Short j pay O/N j Long i get O/N i 14

Arbitrage mechanics SPOT FUNDING pay pay pay pay Short j O/N j O/N j O/N j O/N j get get get get Long i O/N i O/N i O/N i O/N i 14

Arbitrage mechanics SPOT FUNDING FORWARD pay pay pay pay Short j Long j O/N j O/N j O/N j O/N j get get get get Long i Short i O/N i O/N i O/N i O/N i 14

Arbitrage mechanics SPOT FUNDING FORWARD pay pay pay pay Short j Long j O/N j O/N j O/N j O/N j OIS j get get get get Long i Short i O/N i O/N i O/N i O/N i 14

Arbitrage mechanics SPOT FUNDING FORWARD pay pay pay pay Short j Long j O/N j O/N j O/N j O/N j OIS j get get get get Long i Short i O/N i O/N i O/N i O/N i OIS i 14

Arbitrage mechanics SPOT FUNDING FORWARD pay pay pay pay Short j Long j O/N j O/N j O/N j O/N j (bid j) (ask j) OIS j get get get get Long i Short i O/N i O/N i O/N i O/N i (ask i) (bid i) OIS i 14

CIP balancing F (1+i*) = (1+i) S Note: S is domestic per foreign currency units. 15

CIP condition F B (1+OIS* B ) = (1+OIS A ) S A 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 S A in the denominator. 16

CIP profits F B (1+OIS* B ) _ (1+OIS A ) S A 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 S A in the denominator. 17

Agenda CIP basics and motivation CIP details CIP initial empirics Some takeaways More empirics A theory of CIP breakdown 18

Libor (no transaction costs) 0.15 Returns, long EURCHF, Libor no tc (% 0.1 0.05 0-0.05 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 4/4/09-0.1-0.15-0.2 19

OIS (no trans costs) 0.15 Returns + OIS no tc (%) 0.1 0.05 0-0.05 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 4/4/09-0.1 Ret long LiborEur w/t tc -0.15 Ret long OISEur no tc -0.2 20

OIS (with trans costs) 0.15 Returns + OIS with tc (%) 0.1 0.05 0-0.05 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 4/4/09-0.1-0.15-0.2 Ret long LiborEur w/t tc Ret long OISEur no tc Ret long OISEur w/ tc, w/t fxtc 21

FX (with trans costs) 0.15 Returns + FX with tc (%) 0.1 0.05 0-0.05 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 4/4/09-0.1-0.15 Ret long LiborEur w/t tc Ret long OISEur no tc Ret long OISEur w/ tc, w/t fxtc Ret long Eur -0.2 22

Agenda CIP basics and motivation CIP details CIP initial empirics Some takeaways More empirics A theory of CIP breakdown 23

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

Libor OIS CIP profits = α + β (Libor-OIS related variable) +... (Libor, no tc) 25

Libor OIS CIP profits = α + β (Libor-OIS related variable) +... (Libor, no tc) β will turn out significant Tell stories about national vs. foreign default risk But uninformative! 25

Other remarks OIS transaction costs hardly affect profits FX transaction costs make a significant difference Similar results for other currency pairs 26

Main message Using more detailed and realistic measures: Fewer, lower & less persistent CIP deviations But deviations remain! Despite our stricter test 27

Main message Using more detailed and realistic measures: Fewer, lower & less persistent CIP deviations But deviations remain! Despite our stricter test We must look further... perhaps at currencies themselves 27

Agenda CIP basics and motivation CIP details CIP initial empirics Some takeaways More empirics A theory of CIP breakdown 28

Long USD positions 0.1 Returns, short EURUSD (%) 0-0.1 1/1/00 1/25/00 2/18/00 3/13/00 4/6/00 4/30/00 5/24/00 6/17/00 7/11/00 8/4/00 8/28/00 9/21/00 10/15/00 11/8/00 12/2/00 12/26/00 1/19/01 2/12/01 3/8/01 4/1/01 4/25/01 5/19/01 6/12/01 7/6/01 7/30/01 8/23/01 9/16/01 10/10/01 11/3/01 11/27/01 12/21/01 1/14/02 2/7/02 3/3/02 3/27/02-0.2-0.3-0.4-0.5 29

Short USD positions 0.5 Returns, long EURUSD (%) 0.4 0.3 0.2 0.1 0-0.1 1/1/00 1/25/00 2/18/00 3/13/00 4/6/00 4/30/00 5/24/00 6/17/00 7/11/00 8/4/00 8/28/00 9/21/00 10/15/00 11/8/00 12/2/00 12/26/00 1/19/01 2/12/01 3/8/01 4/1/01 4/25/01 5/19/01 6/12/01 7/6/01 7/30/01 8/23/01 9/16/01 10/10/01 11/3/01 11/27/01 12/21/01 1/14/02 2/7/02 3/3/02 3/27/02 30

Further clues Very similar charts for other currency pairs long dollar short dollar ( ) profits (+) profits CIP deviations seem to be currency specific (dollar) directional (short dollar) 31

Agenda CIP basics and motivation CIP details CIP initial empirics Some takeaways More empirics A theory of CIP breakdown 32

Short USD profitable F B S A (1+OIS EUR ) > (1+OIS USD ) 33

Short USD profitable F B S A (1+OIS EUR ) > (1+OIS USD ) F B too high USD too cheap on FWD market 33

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

An illustration 35

An illustration EURUSD t 35

An illustration EURUSD Speculators Investors t 35

An illustration EURUSD Speculators Investors spot t 35

An illustration EURUSD Speculators forward Investors spot t 35

An illustration EURUSD Speculators CIP forward i-rate diff Investors spot t 35

An illustration EURUSD Speculators forward CIP i-rate diff forward excess USD depreciation; CIP breakdown Investors spot t 35

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

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

Regressions support our story Long USD Short USD BAS fwd BAS spot Balance sheet TED VIX/ CDS 38

Regressions support our story BAS fwd BAS FWD Long USD Short USD Funding liquidity constraint BAS spot Balance sheet TED VIX/ CDS 38

Regressions support our story BAS fwd BAS FWD Long USD Short USD Funding liquidity constraint BAS spot Balance sheet TED Risk VIX/ CDS 38

Regressions support our story Long USD Short USD Funding liquidity constraint BAS fwd BAS FWD BAS spot Balance sheet TED + + + + Risk VIX/ CDS no no 38

Regressions support our story Long USD BAS fwd BAS spot Balance sheet TED 5.7 *** + 4.9 *** + 4.4 *** 1.7 *** VIX/ CDS no not signft 39

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

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

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

Appendix 43

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

CHF story similar to above 0.15 Returns + FX with tc (%) 0.1 0.05 0-0.05 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 4/4/09-0.1-0.15 Ret long LiborEur w/t tc Ret long Eur -0.2... as seen in Libor CIP measure, but not with our measure due to significant increase in transaction costs 45

USDEUR, Libor and Net 0.5 Returns, long EURUSD (%) 0.4 Libor, no trans costs 0.3 OIS & FX with trans costs 0.2 0.1 0-0.1 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 46