Persistent deviations from the covered interest parity no-arbitrage condition are viewed as evidence of the new and central role of balance sheet constraints and financial market frictions since the Global Financial Crisis. This column argues that covered interest parity deviations are not a recent phenomenon. Deviations have been the norm over the past 60 years, with the notable exception of the years immediately preceding the crisis, when the condition held unusually closely. Furthermore, financial market frictions are not unique to the post-Global Financial Crisis era, but a persistent feature of foreign exchange and money markets over the longer run.
Covered interest parity (CIP) is the most classical no-arbitrage condition in international finance. CIP holds that a currency’s forward discount against another in the foreign exchange swap market should be equal to the interest rate differential between the two currencies in the money markets. Otherwise, a virtually riskless arbitrage opportunity would arise. For example, suppose that the interest rate differential between the pound sterling and US dollar is greater than the pound’s forward discount against the dollar. An investor could borrow dollars on the money market, convert them into pounds, lend the pounds, fully hedge the exchange rate risk by selling the pounds forward, and lock in a positive return. Instead, when covered interest parity holds, the cost of borrowing US dollars on the money market equals the cost of borrowing them synthetically through a combination of a foreign currency loan and foreign exchange swap contract, so that no arbitrage opportunity exists.
While covered interest parity was previously considered an essential aspect of the functioning of money and foreign exchange markets, a large literature has documented that substantial deviations from this no-arbitrage condition have emerged and persisted among G10 currencies since the 2007/08 Global Crisis (Borio et al. 2016, Du et al. 2018, Cerutti et al. 2020, Du and Schreger 2022, Rime et al. 2022). Scholars have attributed these deviations to the tighter balance sheet constraints faced by financial intermediaries since the Global Financial Crisis, which have significantly reduced their arbitrage capacity (Borio et al. 2016, Du et al. 2018, Avdjiev et al. 2019, Cenedese et al. 2019, Rime et al. 2022). Hence, covered interest parity deviations have been interpreted as evidence of the new and central role of financial market frictions in the post-Global Financial Crisis era.
In a recent paper (Accominotti et al. 2026), we put the post-Global Financial Crisis collapse of the covered interest parity into a long-run perspective. Using a newly assembled daily dataset of spot exchange rates, foreign exchange swap rates, and money market interest rates hand-collected from historical newspapers and covering 19 advanced economy currencies, we provide a systematic empirical assessment of the covered interest parity condition over more than six decades (1963-2025).
Figure 1 British pound’s three-month US dollar basis, 1968-2025
Contrary to the conventional wisdom, we find that the sizeable covered interest parity deviations observed since the Global Crisis are far from exceptional when viewed over the longer run. Over the last six decades, substantial covered interest parity deviations have been the norm, and the minimal deviations observed in the period just before the Global Crisis stand out as the exception. Figure 1 illustrates this pattern by plotting a standard indicator of covered interest parity deviations for the pound sterling: the three-month US dollar basis, defined as the difference between the US dollar money market interest rate and the synthetic US dollar interest rate obtained from a foreign-exchange-hedged investment in a sterling deposit. Absent financial frictions (and setting aside transaction costs for now), any non-zero US dollar basis indicates the presence of a riskless arbitrage opportunity. As Figure 1 shows, substantial deviations from covered interest parity have been present most of the time since the 1960s. Deviations were equally frequent and large pre- and post-Global Financial Crisis, except in the years immediately preceding the crisis when they shrank sharply. This pattern is consistent across all advanced economy currencies in our sample during the 1963-2025 period.
Of course, covered interest parity deviations in the earlier decades of our sample could be due to the presence of capital controls, which were widespread among advanced economies until the mid-1980s. They could also reflect the higher transaction costs in foreign exchange markets in these decades. We can, however, rule out these two explanations. Firstly, to assess covered interest parity deviations while abstracting from the effect of capital controls, we consistently measure them using offshore interest rates (interbank Eurocurrency deposit rates). In the offshore interbank market, which emerged in the early 1960s, global banks could freely accept deposits and extend loans in US dollars and other foreign currencies without being subject to capital controls. Second, to account for transaction costs, we make use of daily bid and ask exchange rate and interest rate quotes. We find that net covered interest parity deviations (i.e. deviations exceeding transaction costs) were equally frequent, and had similar magnitudes, in the pre-2000 and post-Global Financial Crisis periods. By contrast, net covered interest parity deviations were much less frequent and significantly smaller in the years 2000-2006.
What explains the presence of these substantial covered interest parity deviations across such a long time period? And why did they disappear temporarily in the few years preceding the Global Financial Crisis? We argue that, as in the post-crisis period, covered interest parity deviations over the long run reflect the evolution of financial intermediary frictions.
A first source of frictions is balance sheet constraints related to banking regulation. We review the regulations facing UK and US banks, the dominant players in the foreign exchange and offshore money markets, and show that these intermediaries were subject to substantial regulatory constraints from the start of our study in the early 1960s until the mid-1990s. However, these constraints loosened in the following decade, creating scope for regulatory arbitrage and lower effective capital levels, until regulation tightened again in the aftermath of the Global Financial Crisis. Following Du et al. (2018), we also show that, in all periods of tight banking regulation since the 1960s, deviations from covered interest parity increase ahead of quarter-end regulatory reporting dates, when banks face tighter balance sheet constraints.
Financial intermediary frictions also arise from fluctuations in the global financial cycle, which affect banks’ balance sheet and risk-taking capacity, and their ability to arbitrage. Indeed, we find that covered interest parity deviations widen during global credit contractions and narrow during booms. Consistent with this view, the years 2000-2006, when the covered interest parity condition held unusually closely, correspond to an exceptional period of both relaxed bank regulation and a global credit boom. Beyond these exceptional circumstances, however, balance sheet constraints appear to have always limited intermediaries’ ability to arbitrage away covered interest parity deviations.
Financial intermediaries with access to both the US dollar money market and synthetic US dollar funding market play a key role in linking these two markets. For example, suppose that, in aggregate, investors’ demand to sell US dollars forward against pounds (driven by hedging or speculative motives) exceeds their demand to buy dollars forward. Intermediaries absorb this imbalance by buying the excess dollars sold forward in the foreign exchange swap market and, to avoid taking on additional exchange rate risk, they offset this position by borrowing dollars and lending pounds in the money market, an operation akin to covered interest parity arbitrage. However, providing such liquidity requires intermediaries to expand their balance sheet, which, in the presence of frictions, is costly. Covered interest parity deviations represent the compensation intermediaries require to offset these balance sheet costs. For example, a negative US dollar basis for the British pound represents their compensation for absorbing an excess supply of forward dollars (against pounds) in the foreign exchange swap market while a positive US dollar basis provides compensation for absorbing an excess supply of forward pounds. One implication is that, in the presence of balance sheet constraints, the sign and magnitude of covered interest parity deviations should reflect imbalances prevailing in foreign exchange swap markets (Ivashina et al. 2015, Du et al. 2018, Du and Schreger 2022, Liao and Zhang 2025, Du and Huber 2026).
Figure 2 US dollar basis and interest rate differential for selected currencies
Our dataset allows us to verify this prediction over a large sample featuring substantial variation in foreign exchange swap market imbalances. One source of imbalance is the interest rate differential relative to the US dollar, which influences the net supply of forward dollars in foreign exchange swap markets through investors’ demand for US dollar assets and their hedging of dollar exposure. Indeed, over the 1963-2025 period, the sign and magnitude of a currency’s US dollar basis co-move strongly with its interest rate differential (Figure 2), and this relationship holds in both the cross-section and time-series of currencies.
Our dataset also allows us to study how covered interest parity deviations behave during episodes of speculative currency pressure. These events are typically characterised by large foreign exchange swap market imbalances as investors hedge their exchange rate risk or speculate against the currency under attack by selling it forward against its anchor currency. Such episodes were common among advanced economies until the late 1990s but have been much less frequent since. Across 265 speculative currency pressure events, we find that, on average, currencies facing a sudden rise in devaluation pressure also experience a sharp increase in their US dollar basis. This rise reflects the increased supply of these currencies in the foreign exchange swap market and intermediaries’ limited ability to absorb the resulting imbalance. By contrast, currencies experiencing revaluation pressure display a decline in their US dollar basis, reflecting investors’ increased demand for these currencies in the foreign exchange swap market.
Overall, our findings indicate that deviations from the textbook covered interest parity no-arbitrage condition have been both large and frequent over the long run, and that financial intermediary frictions and balance sheet constraints have been long-lasting drivers of these deviations. These frictions are not unique to the post-Global Financial Crisis era. Instead, they have been a persistent feature of money and foreign exchange markets over the last six decades.
Source : VOXeu
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