Title: Preferred habitat, policy, and the CIP puzzle
Authors: Paul Wohlfarth - Birkbeck University of London (United Kingdom) [presenting]
Abstract: The purpose is to examine the impact of policy and market segmentation on the failure of covered interest parity, CIP, a crucial no-arbitrage condition in international finance. The framework integrates market segmentation on fixed income markets, using preferred habitat theory, into an augmented CIP condition with intermediation costs. It highlights the interplay between policy, risk, and structural factors and the role of arbitrage in an endogenous channel for intermediation frictions. We estimate policy transmission channels in EGARCH-in-Mean models of USD/EUR cross currency basis swap (CCBS) rates across maturities. Our findings provide evidence for direct and indirect policy transmission effects on FX swap markets, affecting means and variances. Analysing co-movement across the CCBS term-structure in a VECM framework provides evidence for time-varying market segmentation that appears to be linked to volatility. Our findings highlight the importance of risk- and policy factors in conjunction with structural intermediation factors for foreign exchange markets.