Regional Liquidity Risk and Covered Interest Parity During the Global Financial Crisis : Evidence from Tokyo, London, and New York

During the global financial crisis, there were substantial deviations from the covered interest parity (CIP) condition. In particular, during the post Lehman period, the US dollar interest rate became very low on the forward market, as compared to the rate suggested by the CIP condition. However, the deviations from the CIP condition varied not only across currencies but also across markets. After presenting a simple model, the following analysis examines the CIP condition between the Japanese Yen and the US dollar and explores how it was violated in Tokyo, London, and New York markets. We show that the US dollar interest rate temporarily became lowest in the New York market soon after the Lehman shock but was lowest in the Tokyo market during the rest of the post Lehman turmoil. This implies that liquidity shortage of the US dollar during the rest of the post Lehman turmoil was most serious in Tokyo time when the New York market is closed. The regression results suggest that both credit and liquidity risks explain the difference across the markets. In particular, coordinated central bank liquidity provision was useful in reducing US dollar liquidity risk. However, we observe varieties of asymmetric effects across the markets