More covered interest parity

Several correspondents were kind enough to send me additional work on covered interest parity.

There are two big questions (and a third at the end): 1) what force pushes prices out of line? 2) what force stops arbitrageurs from taking advantage of it, and thereby pushing prices back in line?

Covered Interest Parity Lost: Understanding the Cross-Currency Basis by Claudio Borio, Robert McCauley, Patrick McGuire, and Vladyslav Sushko (also "The Failure of Covered Interest Parity") 

point out that the price whose variation drives arbitrage is the forward rate.  

Interest rates in the cash market and the spot exchange rate can be taken as given – these markets are much larger than those for FX derivatives. Hence, it is primarily shifts in the demand for FX swaps or currency swaps that drive forward exchange rates away from CIP and result in a non-zero basis 

So who is putting pressure on forward markets?

More good finance articles

The February Issue of the Journal of Finance made it to the top of my stack, and it has a lot of good articles. The first two especially caught my attention, Who Are the Value and Growth Investors? by Sebastien Bertermeier, Larent Calvet, and Paolo Sodini, and Asset Pricing Without Garbage by Tim Kroencke. A review, followed by more philosophical thoughts.

I  Bertermeier, Calvet, and Sodini. 

Background: Value stocks (low price to book value) outperform growth stocks (high price to book value). Value stocks all move together -- if they fall, they all fall togther -- so this is a "factor risk" not an arbitrage opportunity. But who would not want to take advantage of the value factor? This is an enduring puzzle.

Covered Interest Parity

Here's how covered interest parity works. Think of two ways to invest money, risklessly, for a year. Option 1: buy a one-year CD (conceptually. If you are a bank, or large corporation you do this by a repurchase agreement). Option 2: Buy euros, buy a one-year European CD, and enter a forward contract by which you get dollars back for your euros one year from now, at a predetermined rate. Both are entirely risk free. They should therefore give exactly the same rate of return, by arbitrage. If european interest rates are higher than US interest rates, then the forward price of the euro should be lower, enough to exactly offset the apparent higher return.  If not, then banks can (say), borrow in the US, go through the european option, pay back the US loan and receive an absolutely sure profit.

Of course there are transactions costs, and the borrowing rate is different from the lending rate. But there are also lots of smart long-only investors who will chase a few tenths of a percent of completely riskless yield. So, traditionally, covered interest parity held very well.

An update, thanks to "Deviations from Covered Interest Rate Parity" by Wenxin Du, Alexander Tepper, and Adrien Verdelhan. (Wenxin presented the paper at Stanford GSB recently, hence this blog post.)

The covered interest rate parity relationship fell apart in the financial crisis. And that's understandable. To take advantage of it, you first have to ... borrow dollars. Good luck with that in fall 2008. Long-only investors had more important things on their minds than some cockamaime scheme to invest abroad and use forward markets to gain a half percent per year or so on their abundant (ha!) cash balances.

The amazing thing is, the arbitrage spread has not really closed down since the crisis. See the first graph. [graph follows]

Source: Du, Tepper, and Verhdelhan

What is going on?

Trade insight

Daniel Hannan, a (soon to be unemployed?) UK member of the European Parliament, writes insightfully about trade in the Saturday Wall Street Journal.

It is telling that neither of the Obama administration’s flagship trade deals—the Transatlantic Trade and Investment Partnership, or TTIP, and the Trans-Pacific Partnership—even had “free trade” in the title. Although they had liberalizing elements, they also contained a great deal of corporatism.

Monitoring TTIP as a member of the European Parliament, I saw plainly enough what was going on: Big multinationals in Europe were getting together with big multinationals in the U.S. and lobbying for more regulation. By combining the most restrictive rules in the EU and the U.S., they aimed to raise barriers to entry and to give themselves an effective monopoly.

There is a deep point here. Our trade treaties have strong elements of managed mercantilism, not free trade, and can serve the interests of global corporations. There is a "better" trade that is also freer trade, and may address some of the political unpopularity of trade deals. Hannan has in mind a very open US-UK bilateral deal, but more deeply states clearly and concisely how better trade deals could work in general

A British-American deal should avoid that danger. How? By focusing on mutual product recognition rather than on common standards. If a drug is approved by the U.S. Food and Drug Administration, it should automatically be approved for sale in the U.K. If a trader can practice in the City of London, he should automatically be licensed to practice on Wall Street. And so on.

A commercial deal, in this case as in any other, should have nothing to do with human rights or child labor or climate change. Important as those issues are, they are separate from the free exchange of products.

... Once Britain no longer has to worry about the protectionism of French filmmakers, Italian textile manufacturers and the rest, we should reach a comprehensive agreement covering services as well as goods. If we make sure that the resulting deal is in the interest of consumers rather than producers, we could revive the whole notion of free trade, which is something the world very much needs just now.

The Real Fed Issues

The media are usually fixated on the angels on heads of pins question, will she or won't she raise rates 0.25%? As such Fed discussion misses many of the really important issues. Fed’s Challenge, After Raising Rates, May Be Existential by Eduardo Porter in the New York Times is an excellent counterexample and a nice primer on some of the really big issues facing the Federal Reserve -- and the nation -- going forward.

Capital Illogic

More Bank Capital Could Kill the Economy write Tim Congdon and the usually sensible Steve Hanke in today's Wall Street Journal.

I was expecting a quantitative disagreement on plausible channels -- some explicit violation of the Modigliani Miller theorem, some reason that splitting the pizza into 8 slices rather than 4 will help your diet, some argument that relationship lending is inherently tied to short-term funding, and so forth. Instead, we got treated to one of the most illogical conclusions I've seen on the WSJ pages for a long time.

Target the spread

What should the Federal Reserve do, to control inflation, given that

nominal interest rate = real interest rate + expected inflation,

and that real interest rates vary over time in ways that the Fed cannot directly observe? In this post I  explore an idea I've been tossing around for a while: target the spread between nominal and indexed bonds, leaving the level of interest rates to float freely in response to market forces. (It follows Long Run Fed Targets and Michelson Morley and Occam.)

Indexed bonds like TIPS (Treasury Inflation Protected Securities) pay an interest rate adjusted for inflation. In simple terms, if a one-year indexed bond offers 1%, you actually get 1% + the rate of CPI inflation at the end of the year. So, with some qualifications (below), markets settle down to

nominal interest rate = indexed rate + expected inflation  

The Fed already uses this fact extensively to read market expectations of inflation from the difference between long-term nominal and indexed rates. 

My modest proposal is that the Fed should (perhaps, see below) target the spread, and thereby force expected inflation to conform to its will. 

Russ Roberts on Economic Humility

Russ Roberts has an excellent essay, What do economists know? on economic humility. (HT Marginal Revolution)

A journalist once asked me how many jobs NAFTA had created or destroyed. I told him I had no reliable idea. ... 

The journalist got annoyed. “You’re a professional economist. You’re ducking my question.” I disgreed. I am answering your question, I told him. You just don’t like the answer. 

A lot of professional economists have a different attitude. They will tell you how many jobs will be lost because of an increase in the minimum wage or that an increase in the minimum wage will create jobs. They will tell you how many jobs have been lost because of increased trade with China and the amount that wages fell for workers with a particular level of education because of that trade. They will tell you that inequality lowers health or that trade with China reduces the marriage rate or encourages suicide among manufacturing workers. They will tell you whether smaller classrooms improve test scores and by how much. And they will tell you things that are much more complex — what caused the financial crisis and why its aftermath led to a lower level of employment and by how much.

And Russ continues, with great clarity, to explain just how uncertain all those estimates are.

So what do economists know? As Russ points out, much of these kind of estimates are not really produced by economics