The Term Structure of Covered Interest Rate Parity Violations

Abstract

ABSTRACT We quantify the impact of risk‐based and nonrisk‐based intermediary constraints (IC) on the term structure of covered interest rate parity (CIP) violations. Using a stochastic discount factor (SDF) inferred from interest rate swaps, we value currency derivatives. The wedge between model‐implied and observed derivative prices reflects the impact of nonrisk‐based IC because our SDF incorporates risk‐based IC. There is no wedge at short horizons, while the wedge accounts for 40% of long‐term CIP violations. Consistent with IC theory, the wedge correlates with the shadow cost of intermediary capital, and the SDF‐implied interest rate is a weighted average of collateralized and uncollateralized interest rates.

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