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Covered interest parity with default risk

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  • Csaba Csávás

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.

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  • Csaba Csávás, 2016. "Covered interest parity with default risk," The European Journal of Finance, Taylor & Francis Journals, vol. 22(12), pages 1130-1144, September.
    • Handle: RePEc:taf:eurjfi:v:22:y:2016:i:12:p:1130-1144
    DOI: 10.1080/1351847X.2014.924076
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    Cited by:

    1. Patrick Augustin & Mikhail Chernov & Lukas Schmid & Dongho Song, 2024. "The Term Structure of Covered Interest Rate Parity Violations," Journal of Finance, American Finance Association, vol. 79(3), pages 2077-2114, June.
    2. Chernov, Mikhail & Augustin, Patrick & Schmid, Lukas & Song, Dongho, 2020. "The term structure of CIP violations," CEPR Discussion Papers 14774, C.E.P.R. Discussion Papers.

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