Wider Covered Interest Parity Deviations and Lower Stock Returns: Evidence from the Eurozone

Financial economists have in recent times begun to analyze the reasons for and determinants of the non-zero cross-currency basis swap spread, a measure of the extent of deviations from covered interest parity (CIP) and risk-less arbitrage. They have however not examined the potential effects of the basis on the market performance of major asset classes, particularly the riskiest asset class – stocks – and how stock markets behave in response to changes in the basis. This paper addresses this question by examining how stock returns in the eurozone respond to changes in and shocks to the euro cross-currency basis. Our results show that there is a positive relationship between changes in the basis and stock market returns. Wider deviations from CIP go pari-passu with declines in stock returns, especially for the long-end basis. The relationship is strongest and most significant during periods of crisis but is generally preserved across the whole sample period. Although the effect of global risk sentiment, proxied by the VIX, on returns is generally the strongest, we show that the positive relation between stock returns and changes in the basis is preserved even after controlling for VIX, dollar exchange rate and other stock-return drivers.