CIP violations shape dynamic cross-currency basis curve

The paper investigates persistent failures of covered interest parity (CIP) in forward currency markets, driven by the search for U.S. dollars and balance-sheet constraints of intermediary dealers.

Applying functional principal component analysis (FPCA) to the daily dynamics of the USD/CHF cross-currency basis curve, the authors identify three key components explaining nearly all curve dynamics.

These include a persistent, slow-moving level component, a temporary steepener, and a short-end component causing sharp basis widenings and contractions around quarter-end dates.

Empirical evidence shows that CIP-implied carry opportunities and U.S. monetary policy announcements widen the entire basis curve, while Fed swap line announcements tend to narrow it.

During global turmoil, the slope inverts due to rising credit and capital stress among dealer banks.

Since the 2008 Global Financial Crisis, CIP deviations have become larger and more persistent, reflecting deeper market frictions.

The literature identifies two main drivers: dealer balance-sheet constraints, exacerbated by post-crisis regulations like Basel III, which increase the cost of supplying USD funding, and structural macrofinancial determinants, such as persistent FX-hedging demand from non-U.S. institutions.

This study moves beyond previous research that typically confined analysis to short-term maturities and regulatory reporting dates, instead examining the full-term structure of CIP deviations to distinguish structural drivers from constraint-induced distortions.