Persistence of Covered Interest Rate Parity Deviations
School of Business | Bachelor's thesis
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AbstractIn this paper I review literature investigating the recent finding of persistent deviations from Covered Interest Rate Parity. I argue with evidence from empirical research papers, that there are various macroeconomic factors contributing to the phenomenon. Most factors are tightly connected to the balance sheets of the agents functioning in the FX market, for which the US Dollar plays a pivotal role. One view is that post-crisis banking regulation drives the deviations in the short run. Another view is that the deviations arise in the first place from imbalances in FX hedging demand of US Dollar. A model that I review explains the deviations with financial frictions arising because of more cautious risk management. A compromise in the middle is that the factors in the demand side of USD hedges open the deviations, and the tightened regulation and risk management raises the costs for arbitrageurs to close them. This paper does not contribute to the existing literature with any new findings. The purpose is rather to combine a few convincing findings of the literature, pointing towards the phenomenon being not only a consequence of one simple exogenous factor, but rather an inefficiency that is affected by various macroeconomic factors.
Thesis advisorLedyaeva, Svetlana
covered interest rate parity, foreign exchange market, macroeconomics, international economics, international capital flows, financial frictions, banking regulation, risk management