A New Testable Theory on Deviations from Covered Interest Rate Parity

Suppose a rational agent can invest in domestic bonds (Euro (EUR) corporates) and foreign bonds (Dollar (USD) corporates) hedged into EUR using cross-currency swaps. Let xccy represent the cross-currency basis spread of the FX hedging, where xccy measures deviations from covered interest parity (CIP), a gauge of potential arbitrage profits in FX derivatives markets, see Du et al. (2018). Under the assumption that the bonds pay some spreads over their domestic benchmark rates, I propose a model that relates xccy to three drivers. First, I show that xccy is determined by 1) credit spreads differential, 2) output differential, and 3) expected inflation differential. Second, I analyze the theoretical predictions of the model, i.e., the effects of the three drivers on xccy. Third, I perform an empirical analysis to verify the theoretical predictions. Finally, I discuss the results in the light of CIP deviations, FX-based arbitrage opportunities and policy