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© 2023 International Monetary Fund
WP/23/28
IMF Working Paper
Strategy, Policy, and Review Department
Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants and Disconnect
Prepared by Eugenio Cerutti and Haonan Zhou*
Authorized for distribution by Ken Kang
February 2023
IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
ABSTRACT: We provide a systematic empirical treatment of short-term Covered Interest Parity (CIP) deviations for a large set of emerging market (EM) currencies. EM CIP deviations have much larger volatilities than most G10 currencies and move in an opposite direction during global risk-off episodes. While off-shore EM CIP deviations are sensitive to changes in FX dealers’ risk-bearing capacities and global risk aversion, on-shore EM CIP deviations are largely unresponsive in segmented FX markets. Moreover, the sensitivity of offshore EM CIP deviations to global risk factors for currencies with segmented FX markets is stronger compared to their counterparts with integrated FX markets. We find weak evidence of country default risk affecting EM CIP deviations after accounting for global factors.
| JEL Classification Numbers: | G15, F31 |
| Keywords: | Covered interest parity; Interest rate differentials; Forward foreign exchange market; Financial market arbitrage; Emerging markets |
| Author’s E-Mail Address: | ECerutti@imf.org, haonan@princeton.edu |
| JEL Classification Numbers: | G15, F31 |
| Keywords: | Covered interest parity; Interest rate differentials; Forward foreign exchange market; Financial market arbitrage; Emerging markets |
| Author’s E-Mail Address: | ECerutti@imf.org, haonan@princeton.edu |
Title Page
WORKING PAPERS
Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants and Disconnect
Prepared by Eugenio Cerutti and Haonan Zhou1
Contents
Introduction
FX Market Development and CIP Deviation Measurement
Time-Series and Cross-Sectional Stylized Facts
Evolution of CIP Deviations
Cross-Sectional Correlations with Macro-Financial Variables
Costly Financial Intermediation and Period End Dynamics
Global Factors and CIP Deviations: On-Shore and Off-Shore Disconnect
Theoretical Underpinnings and Hypotheses: Basis Sensitivity, Costly Financial Intermediation, and Segmented Markets
Regression Evidence
CIP Deviations and Country Specific Correlates
Discussion and Policy Implications
References
FIGURES
Figure 1: Benchmark Offshore 3-Month CIP Deviations
Figure 2: CIP Deviations and Macro Correlates Across Countries (2010–2021)
Figure 3: Quarter-End Dynamics for 1 Month Bases
Figure 4: Year-End Dynamics for 3-Month Basis, by Groups of Currencies .
Figure 5: Offshore-Onshore CIP Deviation Spread (pp)
Figure 6: Average CIP Deviations During Global Risk-Off Episodes: Currencies with Segmented FX Forward Markets .
Figure 7: Global Factor -β (2010–2021) for Currencies with Forward-Market Segmentation
TABLES
Table 1: Average CIP Deviations by Currency (bps)
Panel (a): Currencies with Wide Offshore/Onshore Forward Differential: Dollar-CP Bases
Panel (b): Non-Deliverable Currencies with Comparable Offshore/Onshore CIP deviations
Panel (c): Currencies with Data on Deliverable Forward, by Types of Dollar Interest Rates
Table 2: CIP Deviations and Global Factors
Panel (a): Baseline Panel Regressions
Panel (b): Add Safe Haven Dollar Factor
Table 3: CIP Deviations and EM-Specific Correlates
Panel (a): Country Default Risk: Residualized CDS Spread
Panel (b): Exchange Rate Expections
Cerutti is at the Strategy Policy and Review Department of the IMF. Zhou is at Princeton University. We thank Agnes Isnawangsih for help with downloading Bloomberg data, Ken Froot for insightful discussion, Jochen Schmittmann for helpful conversations, and Suman Basu, Lukas Boer, Sonali Das, Ken Kang, Jorge Leon, Monica Petrescu, Carlos de Barros Serrao, Tatjana Schulze, Yizhi Xu for comments. Zhou acknowledges generous financial support from the International Economics Section and the Griswold Center for Economic Policy Studies at Princeton University. The opinions expressed herein are solely the responsibility of the authors and should not be interpreted as reflecting hose of the IMF, its Executive Board, or IMF management.