The Failure of Covered Interest Parity: FX Hedging Demand and Costly Balance Sheets
The failure of covered interest parity (CIP) or, equivalently, the persistence of the cross currency basis, in tranquil markets has presented a puzzle. Focusing on the basis against the US dollar (USD) we show that the CIP deviations that are not due to transaction costs or bank credit risk can be explained by the demand to hedge USD forward. Fluctuations in FX hedging demand matter because committing the balance sheet to arbitrage is costly. With limits to arbitrage, CIP arbitrageurs charge a premium in the forward markets for taking the other side of FX hedgers' demand. We find that measures of FX hedging demand, combined with proxies for the risks associated with CIP arbitrage, improve the explanatory power of standard regressions.