Covered interest parity with default risk

Abstract

In this paper we derive a simple model of covered interest parity (CIP) with the assumption that interbank money market rates are risky. The model assumes that the default risk of uncollateralised loans can be hedged perfectly by credit default swap contracts. We show that the no-arbitrage condition is satisfied by a band. The location of this no-arbitrage band depends on the relative riskiness of the two counterparties in the CIP trade. We present evidence on the performance of the model for developed currency pairs in 2008–2011. We find that FX swap spreads (CIP deviations calculated from interbank interest rates of two countries) either fluctuated within the no-arbitrage bands or were close to the edges of the no-arbitrage bands.

Keywords:

• FX swap spread
• covered interest parity
• default risk
• crisis

JEL Classification:

• F31
• G13
• G21

Notes

1. If the CDS market maker paid earlier than the original maturity, the banks should place the received amount at a new interest rate and hedging it with a new CDS. Alternatively, it could close the remaining positions of the arbitrage trade which would entail price risk.

2. Differently from Libor rates, we have no information about how the panel composition changed in the past. The panel valid at the end of 2011 is used for both currencies.