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.

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

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

t

tFt

Dt

s

f

i

i

1

1

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:

Ftt

tDt i

s

fi 11

rateinterest 11 USDis

fBasis F

tt

tDt

)$1(1rate $

rate $tt

t

tDt LIBOReuroLIBOR

spoteuro

forwardeuroBasis

4

-10

60

130

200

270

-50

125

300

475

650

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08

Bas

is P

oin

ts

Bas

is P

oin

ts

Date

Implied Rate(Left Axis)

USD LIBOR(Left Axis)

Basis = Implied Rate - USD LIBOR(Right Axis)

September 15

Source: Reuters, FRBNY calculations

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

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09-10

40

90

140

190

240

Basis_hourly Basis_daily

Date

Bas

is P

oin

ts

Basis > 0 after Aug 07, high correlation between two measures

)$1(1rate $

rate $tt

t

tDt LIBOReuroLIBOR

spoteuro

forwardeuroBasis

7

CIP Deviations: Alternative $ Interest Rates

0

100

200

300

400

500

600

-50

0

50

100

150

200

250

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09

Basi

s Po

ints

Basi

s Po

ints

Date

Basis NYFR basis Treas basis

If Libor understated, basis artificially positiveSee also Schwarz (2009) on Libor mismeasurement

)$1(1rate $

rate $tt

t

tDt LIBOReuroLIBOR

spoteuro

forwardeuroBasis

8

CIP Deviations: Alternative FX Rates

-50

0

50

100

150

200

250

Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09

Basi

s Po

ints

Date

USD/JPY

USD/CHF

GBP/USD

NZD/USD

AUD/USD

)$1(1rate $

rate $tt

t

tDt LIBOReuroLIBOR

spoteuro

forwardeuroBasis

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

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

Empirical Proxy for Market Liquidity Risk

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)

1/1/2007-7/31/2007 8/01/2007 - 9/15/2008 9/16/2008 - 3/31/2009 Explanatory

variable Estimate t-stats Estimate t-stats Estimate t-stats

Intercept 1.007 1.066 0.744 0.300 -49.744* -1.967

Lag Basis -0.008 -0.077 0.882** 27.111 0.731** 10.206

Liquidity Risk

MBS-T ON 1.152** 2.468 -0.676 -1.063 34.233** 4.810

TED 0.012* 1.935 0.009 1.127 -0.207** -3.107

PAR-OTR -0.149 -1.468 0.191** 2.347 -0.077 -0.384

Counterparty Risk

CDX -0.002 -0.159 0.003 0.236 0.066 0.910

Disp. -0.523** -2.573 0.072 0.727 0.516** 3.008

Market Risk

VIX -0.023 -0.513 -0.148 -1.464 0.822** 3.918

EVOL -0.098 -1.155 -0.049 -0.204 1.312 1.855

Adj. R2 0.128 0.889 0.836

OBS 139 266 132

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

Dates Announcement

12/12 /2007Swap line arrangements with European Central Bank (ECB) and Swiss National Bank (SNB) announced. Agreement for 6 months.

1/10 /2008 ECB announces two TAF auctions for January 2008.

2/01/2008 ECB announces it will not participate in February auctions.

3/11/2008 Size of swap lines with ECB and SNB expanded.

5/2/2008 Increased size of swap lines with ECB, SNB and extension of program. Program extended till Jan 30 2009.

7/30/2008 ECB, SNB announce establishment of 84 day TAF auctions.9/18/2008 Further expansion of swap lines with ECB and SNB. New swap line

arrangements with Bank of Canada (BOC), Bank Of England (BOE),

and Bank of Japan (BOJ).9/24/2008 New swap line arrangements with Royal Bank of Australia, Danmark

Nationalbank, Norges Bank and Sweden Rijksbank.9/26/2008 Expanded swap line size with ECB, SNB announced.9/29/2008 Increased swap line sizes with ECB, SNB, BOC, BOE, BOJ, and

Danmark Nationalbank, Norges Bank and Sweden Rijksbank.

Agreements extended till April 30 2009.10/13/2008 Expansion of swap line sizes with ECB, SNB and BOE.10/14/2008 Expansion of swap line sizes with BOJ.10/28/2008 Initiate swap line arrangement with Royal Bank of New Zealand.10/29/2008 FED announces swap line arrangements with Banco Central do Brasil,

Banco de Mexico, Bank of Korea, and the Monetary Authority of

Singapore.02/03/2009 FED announces extension of swap line arrangements to October 30

2009

Now extended to Feb. 1, 2010, amounts outstanding will remain on balance sheet for a few months afterwards

BOJ expected; Capital injection on 10/14

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!

5/23/2008 - 9/15/2008 9/16/2008 - 3/31/2009 Explanatory

variable Estimate t-stats Estimate t-stats

Intercept -0.098 -0.285 0.073 0.048

Swap ann. -5.258** -4.470 16.189 0.905

Swap line size uncapped

--- --- -77.724** -10.835

$ auctions -1.279 -1.685 -1.584 -0.574

CONTROLS YES YES

Adj. R2 0.180 0.193 OBS 76 130

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

Example: European investor buys US T-bill

U.S. Treasury Bill

European investor who has Euros and wantsto buy U.S. Treasury bill

Counterparty to FX Swap

Start: USD for bill

purchase

Maturity: final USD payment

Start: USD cash

Start: EUR cash

Maturity: EUR cash

Maturity: USD cash

FX Swap