Capital Constraints, Counterparty Risk, and Deviations from Covered Interest Rate Parity

1. Capital Constraints, Counterparty Risk, and Deviations from Covered Interest Rate Parity January 2, 2010 The opinions expressed here are those of the authors and do not reflect those of the Federal Reserve Bank of New York or the Federal Reserve System. Niall Coffey, Warren B. Hrung, and Asani Sarkar

2. Rise in Funding Costs • Covered Interest Rate Parity relation • Apparent deviations from Law of One Price during crisis • Eurodollar interest rates in NY and London (McAndrews, 2009) • CDS-Corporate bond basis (Garleanu and Pedersen, 2009) • Interest rate swap spread (Krishnamurthy, 2009) • Limited capital of arbitrageurs Illiquidity • Riskless cash flows became risky during crisis

3. Estimating CIP Deviations • Covered Interest Rate Parity relation • No prior evidence of persistently large deviations (LTCM?) • Arbitrage supposed to work in FX markets (Shleifer and Vishny, 1997) • Borrow dollars vs. borrow euros and swap into dollars • Implied rate: solve for iD using data on FX rate and iF • Dollar basis—should be zero if CIP holds—pos/neg basis is violation of CIP:

4. Basis increased in Aug. 2007, not a leading indicator

5. Outline • Robust evidence of CIP deviations during crisis • Different USD interest rates • Different USD-FX currency pairs • Explain deviations • Empirical proxies for margin constraint and cost of capital • Empirical proxies for counterparty credit risk • Effect of Fed’s currency swap lines on CIP deviations • Concluding remarks

6. CIP Deviations: LIBOR, euro$ FX Basis > 0 after Aug 07, high correlation between two measures

7. CIP Deviations: Alternative $ Interest Rates If Libor understated, basis artificially positive See also Schwarz (2009) on Libor mismeasurement

8. CIP Deviations: Alternative FX Rates Non-dollar bases expected to be zero

9. Focus on Two Explanations • Arbitrageurs are capital-constrained • Unexploited profit opportunity • Arbitrage is risky • Prices efficiently reflecting risk

10. Empirical Proxy for Margin Constraint • Tightness of margin condition: O/N Repo (funding) rates • MBS-GC spread = Repo rate on Agency MBS securities – General collateral repo rate (Treasury securities) • 3M spreads not as liquid, more counter-party risk • Results also in paper • Repo rates, not yields: return on collateralized funding + incorporates perception of illiquidity • Both rates collateralized, so difference reflects relative illiquidity of MBS securities and margin differences • Caveat: Fed intervention (TSLF) affected the spread (Fleming, Hrung, and Keane, 2009, 2010)

11. Empirical Proxy for Market Liquidity Risk • 10 yr Par-OTR yield spread • Par bond hypothetical from FRB • Abstract from any specialness for actual bonds • Liquidity in Tsy market proxy for systematic market liquidity risk • Impact ambiguous: illiquidity reduces supply of dollars, but also increases unsecured interest rates

12. Empirical Proxy for Cost of Capital • Garleanu and Pedersen (2009):Cost of capital = Rate on uncollateralized funds – Rate on collateralized funds • 3M TED spread = LIBOR – Treasury bill rate • 3M LIBOR-GC repo rate = LIBOR – GC repo rate • LIBOR on both sides of regression—Baba and Packer (2008)—results similar if use NYFR in basis calculations

13. Empirical Proxy for Risk Measures • Counterparty risk • CDX: CDX IG index of CDS prices (average default risk) • DISPERSION: Max – Min 3M LIBOR quote of LIBOR panel banks (uncertainty about risk level) • Market Risk • VIX: Equity implied volatility • EVOL: FX implied volatility

14. CIP Deviations, Risk Measures (with TED spread) Levels regression; TED: more impact on dollar rates than euro rates

15. Fed’s Currency Swap Line Program • Ease shortage of US dollars in short-term international money markets • Example: ECB holds auctions with banks in its jurisdictions • Fed swaps USD for euros with ECB for amount auctioned • Fed exposure is to ECB, not banks • Use change in basis to better isolate impact of program • Regress on dummies for announcements and auction dates • Control for credit risk but not liquidity risk (collinearity)

16. Central Bank Swap Lines Announcements BOJ expected; Capital injection on 10/14 Now extended to Feb. 1, 2010, amounts outstanding will remain on balance sheet for a few months afterwards

17. Central Bank Swap Line Utilization Source: H4.1

18. Effect of Fed’s Swap Lines on CIP Deviations: Hourly Euro-USD FX data Analysis in first differences now—problem with Baba and Packer (2008) Credit risk and other controls, but no liquidity risk controls Scott Frame to the rescue!

19. Concluding remarks • Robust evidence of large and persistent CIP deviations during crisis • Explained in part by proxies for arbitrageurs’ capital constraints • Counterparty credit risk also important after Lehman • Fed’s currency swap lines program reduced CIP deviations • Next steps: bid/ask values in calculations, investigate 1M-12M bases, other currency pairs (expect basis close to 0); basis for individual Libor panel banks

20. U.S. Treasury Bill Start: USD for bill purchase Maturity: final USD payment European investor who has Euros and wants to buy U.S. Treasury bill Start: USD cash Maturity: USD cash Maturity: EUR cash Start: EUR cash FX Swap Counterparty to FX Swap Example: European investor buys US T-bill