Credit migration and covered interest rate parity

This paper examines the joint determination of deviations in long-term covered interest rate parity and differences in the credit spread of bonds of similar risk but different currency denomination. These two pricing anomalies are highly aligned in both the time series and the cross-section of curre...

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Published in:	Journal of financial economics Vol. 138; no. 2; pp. 504 - 525
Main Author:	Liao, Gordon Y.
Format:	Journal Article
Language:	English
Published:	Amsterdam Elsevier B.V 01.11.2020 Elsevier Sequoia S.A
Subjects:	Arbitrage Bonds Corporate debt Covered interest rate parity Credit Credit spread Currency Debt Debt financing (Corporations) Debt issuance Federal Reserve banks Financial economics Foreign exchange Foreign exchange rate hedging Hedging (Finance) Interest rate parity theorem Interest rates Limits of arbitrage Migration Monetary policy Prices and rates Time series Debt issuance E44 F55 G32 G12 G23 G15 G28 F3 Foreign exchange rate hedging Credit spread Limits of arbitrage Covered interest rate parity
ISSN:	0304-405X, 1879-2774
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Abstract	This paper examines the joint determination of deviations in long-term covered interest rate parity and differences in the credit spread of bonds of similar risk but different currency denomination. These two pricing anomalies are highly aligned in both the time series and the cross-section of currencies. The sum of these two pricing deviations—the corporate basis—represents the currency-hedged borrowing cost difference between currency regions and explains up to a third of the variation in the aggregate corporate debt issuance flow. I show that arbitrage aimed at exploiting one type of security anomaly can give rise to the other.
AbstractList	This paper examines the joint determination of deviations in long-term covered interest rate parity and differences in the credit spread of bonds of similar risk but different currency denomination. These two pricing anomalies are highly aligned in both the time series and the cross-section of currencies. The sum of these two pricing deviations-the corporate basis-represents the currency-hedged borrowing cost difference between currency regions and explains up to a third of the variation in the aggregate corporate debt issuance flow. I show that arbitrage aimed at exploiting one type of security anomaly can give rise to the other.
Audience	Academic
Author	Liao, Gordon Y.
Author_xml	– sequence: 1 givenname: Gordon Y. surname: Liao fullname: Liao, Gordon Y. email: gliao@post.harvard.edu organization: Federal Reserve Board, 20th and C Streets NW, Washington D.C. 20551, United States
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Keywords	Debt issuance E44 F55 G32 G12 G23 G15 G28 F3 Foreign exchange rate hedging Credit spread Limits of arbitrage Covered interest rate parity
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Snippet	This paper examines the joint determination of deviations in long-term covered interest rate parity and differences in the credit spread of bonds of similar...
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SubjectTerms	Arbitrage Bonds Corporate debt Covered interest rate parity Credit Credit spread Currency Debt Debt financing (Corporations) Debt issuance Federal Reserve banks Financial economics Foreign exchange Foreign exchange rate hedging Hedging (Finance) Interest rate parity theorem Interest rates Limits of arbitrage Migration Monetary policy Prices and rates Time series
Title	Credit migration and covered interest rate parity
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