International Finance Discussion Papers (IFDP)
Credit Migration and Covered Interest Rate Parity
Gordon Y. Liao
This paper examines the connection between deviations in covered interest rate parity and differences in the credit spread of bonds of similar risk but different currency denomination. These two pricing anomalies are highly aligned in both the time series and the cross-section of currencies. The composite of these two pricing deviations – the corporate basis – represents the currency-hedged borrowing cost difference between currency regions and explains up to a third of the variation in the aggregate corporate debt issuance flow. I show that arbitrage aimed at exploiting one type of security anomaly can give rise to the other.
Keywords: Covered interest rate parity, limits of arbitrage, credit market segmentation, debt issuance, dollar convenience yield, foreign exchange rate hedge
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