Covered interest rate parity, relative funding liquidity and cross-currency repos

Dr. Daniel Kohler and Dr. Benjamin Müller

Issue
2019-05

Pages
33

JEL classification
E43, F31, G12, G14, G15

Keywords
Covered interest rate parity, FX swap market, cross-currency repos, funding

Year
2019

Deviations from the covered interest rate parity (CIP) are considerably smaller or even zero when calculated based on a particular set of repo rates, so-called cross-currency repo rates, instead of standard interest rates, such as overnight indexed swap or Interbank Offered rates. We attribute this (partial) solution of the CIP puzzle to the nearly identical risk characteristics of foreign exchange swaps and cross-currency repos: both are virtually devoid of counterparty credit risk but incorporate a relative funding liquidity premium. In practice, CIP deviations can thus be exploited on a truly riskless basis using cross-currency repo transactions, which is not the case for other interest rates.