The Term Structure of Covered Interest Rate Parity Violations
53 Pages Posted: 26 May 2020 Last revised: 29 May 2022
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The Term Structure of Covered Interest Rate Parity Violations
The Term Structure of Cip Violations
Date Written: May 2020
Abstract
We quantify the impact of risk-based and non-risk-based intermediary constraints (IC) on the term structure of CIP violations. Using a stochastic discount factor (SDF) inferred from interest rate swaps, we value currency derivatives. The wedge between model-implied and observed derivative prices reflects the impact of non-risk-based IC because our SDF incorporates risk-based IC. There is no wedge at short horizons, while the wedge accounts for 40% of long-term CIP violations. Consistent with IC theory, the wedge correlates with the shadow cost of intermediary capital, and the SDF-implied interest rate is a weighted average of collateralized and uncollateralized interest rates.
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