The Failure of Covered Interest Parity : FX Hedging Demand and Costly Balance Sheets

The failure of covered interest parity (CIP), or, equivalently, the persistence of cross-currency basis, in tranquil markets has posed a puzzle. By analysing the term structure of CIP deviations, we empirically establish that imbalances in the demand for and supply of FX hedges exert first order effects on the level of CIP deviations. Fluctuations in FX hedging demand move forward exchange rates out of line with CIP because, in aggregate, financial institutions charge a premium for provisioning for risks associated with exposures to FX derivatives needed to supply FX hedges. We also find that the elasticity of CIP deviations to changes in FX hedging demand can be explained with proxies for FX collateral risk. Our findings point to a fundamental change in the relationship between prices and quantities in FX derivatives markets on which CIP is predicated, suggesting that the notion of CIP as a no-arbitrage condition may be obsolete