How does covered interest parity work and when does it break down?

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AcadiFi · Accepted Answer

Covered interest parity (CIP) states F/S = (1 + i_domestic)/(1 + i_foreign), where F is the forward rate and S is spot. It eliminates currency risk by locking forward rate. Arbitrage trade: borrow in low-yield currency, convert spot, invest in high-yield, sell forward. Any deviation from CIP offers risk-free profit.

Pre-2008 CIP held extremely tightly across major currencies, with deviations under 5 basis points. Post-2008 CIP has broken persistently: EUR/USD CIP deviations averaged 30-50bps, widening to 200+bps during stress (Dec 2016 year-end squeeze). This is called the 'cross-currency basis.'

Why the breakdown? Regulatory capital requirements (Basel III) made bank balance sheet space expensive, so banks demand compensation for providing forward FX hedges. Quarter-end and year-end spikes reflect regulatory reporting dates. Saffron Cross-Asset Fund exploits these basis widenings by being willing to take balance-sheet capacity when others cannot.

Consequences: issuers swap-hedged cross-currency borrowing gets more expensive; funds hedging foreign bond portfolios pay more for protection. CIP is no longer a pure arbitrage but a signal of balance-sheet stress. Wide deviations persist even years later, contradicting the textbook view of CIP as an inviolable no-arbitrage condition.

How does covered interest parity work and when does it break down?

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