The Dynamics of Interest Parity Deviations : The Role of Liquidity

This working paper is written by Cho-Hoi Hui (Hong Kong Monetary Authority), Paul Luk (Hong Kong Institute for Monetary and Financial Research), Giorgio Valente (Hong Kong Institute for Monetary and Financial Research) and Gabriel Wu (Hong Kong Monetary Authority).We study the joint time-variation of deviations from the Covered and Uncovered Interest Parities (CIP, UIP respectively) using an empirical framework that allows for the two variables to be endogenously determined. We interpret the empirical findings based on the interaction of funding and market liquidity in the foreign exchange market. We find that positive shocks to CIP deviations have a significant and negative effect on UIP deviations. The low interest rate funding currencies, which are more liquid and less sensitive to shocks in foreign exchange liquidity, tend to appreciate when funding liquidity tightens. However, since funding currencies are in the short position under the carry trade strategy we consider, this results in a net reduction of overall carry trade returns, i.e. lower UIP deviations. A lower UIP deviations, on the other hand, results in a reduction in CIP deviations