Funding liquidity risk and deviations from interest-rate parity during the financial crisis of 2007-2009

Significant deviations from covered interest parity were observed during the financial crisis of 2007–2009. This paper finds that before the failure of Lehman Brothers market-wide funding liquidity risk was the main determinant of these deviations measured by swap-implied US dollar (USD) interest rates for the euro, British pound, Hong Kong dollar, Japanese yen, Singapore dollar and Swiss Franc relative to US Libor rates. This evidence suggests that the deviations can be explained by the existence and nature of liquidity constraints. After the Lehman default, both counterparty risk and funding liquidity risk in the European economies were the significant determinants of the positive deviations found for these currencies, while the tightened liquidity condition in the USD was the main driving factor of the negative deviations in the Hong Kong, Japan and Singapore markets. The negative deviations reflect the fact that these markets became alternative dollar funding sources as borrowing in the European economies became more difficult. Federal Reserve Swap lines with other central banks that eased the liquidity pressure reduced the positive deviations in the European economies.