IMF Working Papers

Covered Interest Parity in Emerging Markets: Measurement and Drivers

By Mai Dao, Pierre-Olivier Gourinchas

March 28, 2025

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Mai Dao, and Pierre-Olivier Gourinchas. "Covered Interest Parity in Emerging Markets: Measurement and Drivers", IMF Working Papers 2025, 057 (2025), accessed April 2, 2025, https://doi.org/10.5089/9798229003995.001

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

We study the behavior of Covered Interest Parity (CIP) deviations – aka the CIP basis - in Emerging Markets (EM). A major challenge in computing the CIP basis in EM’s lies in measuring local currency interest rates which are free of local credit risk. To do so, we construct a ‘purified’ CIP basis for eight major EM currencies using supranational bonds issued in EM local currencies and US dollar going back twenty years. We show that this ‘purified’ CIP basis aligns well with theory-implied predictions. In the cross-section and the timeseries, the basis correlates with fundamental forces driving supply and demand for dollar forwards. Shocks to global dollar funding costs, global intermediary’s balance sheet capacity, and the demand for dollar safe assets interact with currency-specific dollar hedging and funding needs in moving the CIP basis in EM’s.

Subject: Bonds, Currencies, Currency markets, Emerging and frontier financial markets, Financial institutions, Financial markets, Financial regulation and supervision, Financial services, Foreign exchange, Hedging, Interbank rates, Interest rate parity, Money, Sovereign bonds, Spot exchange rates, Yield curve

Keywords: Bonds, Covered Interest Parity, Currencies, Currency markets, Emerging and frontier financial markets, Emerging markets, Forward exchange rates, Global, Hedging, Interbank rates, Interest rate parity, Intermediation frictions, Sovereign bonds, Spot exchange rates, Yield curve

Publication Details

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