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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. - PowerPoint PPT Presentation
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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