Covered Interest Parity Deviations under the Control of Credit Default Swap Spread and Central Bank Intervention

This study investigated dislocations in the Korean foreign exchange(FX) swap market and focused on the credit risk of financial institutions, which is reflected in the FX swap price. Both the credit default swap spread of US financial institutions and that of Hana Bank were positively related to the covered interest parity(CIP) deviation observed in the FX swap market before the Lehman failure. However, after the turmoil, FX swap deviations tended to depend more on US financial institutions with investment grade rating than on Korean financial institutions. Our findings suggested that the concern over the counterparty risk and dollar shortages of US financial institutions under crisis was an important driving force behind the deviation from CIP in the FX swap market. Liquidity conditions in the Libor funding markets mattered more to FX swap markets during the turmoil than before the turmoil. However, central bank measures to counter the dollar shortages were effective. Our empirical evidence suggests that the establishment of dollar swap lines became useful in diminishing the level of FX swap market deviation.