Regional Liquidity Risk and Covered Interest Parity during the Global Financial Crisis :

Abstract During the global financial crisis, there were substantial deviations from covered interest parity (CIP) condition. In particular, during the post Lehman period, the US dollar interest rate became very low on the forward market, as compared to the rate suggested by the CIP condition. However, the deviations from CIP condition varied not only across currencies but also across markets. After presenting a simple model, the following analysis examines how the CIP condition between the Japanese yen and the US dollar was violated in Tokyo, London, and New York markets. We show that the US dollar interest rate became lowest in the New York market soon after the Lehman shock but was lowest in the Tokyo market during most of the turmoil period. The regression results suggest that credit risk in interbank markets and central banks’ liquidity provisions explain the difference across the markets. However, we observe varieties of asymmetric effects across the markets.