Deviations from covered interest rate parity: The role of banking regulation, the U.S. dollar and market volatility

Abstract

Covered interest rate parity (CIP), one of the most fundamental principles of international finance, fell apart during the global financial crisis of 2008-2009, and deviations from the parity continue to exist. This thesis looks into the reasons behind the deviations with special interest in the role of banking regulation, market volatility, and the U.S. dollar, which has a unique role in the international financial system. Using data from the post global financial crisis period and four major currencies, EUR, GBP, JPY and CHF, against USD, I find statistically significant quarter-end widening in the CIP deviations, which supports the hypothesis that financial intermediaries window-dress their reporting at quarter-ends by reducing derivatives positions to comply with regulation. The quarter-end widening found in the data is larger after stricter regulatory reporting requirements in 2015 and smaller after temporary loosening of the regulation. Additionally, the strength of USD and volatility in the market measured by VIX index seem to coincide with wider CIP deviations.