I forget where I read it, but sombody at sometime held up the forwards market on foreign exchange as being the most efficient market anywhere. Plug in the spot rate and the two relevant risk-free rates for any two currencies and presto! you have the forward rate to as many decimal places as you want.
Like everything else in this market, this model is no longer as valid as it used to be: the implicit assumptions in the model are infinite liquidity and counterparty strength, neither of which are as very nearly true as they used to be. The Bank for International Settlements has released Working Paper #267 titled Interpreting deviations from covered interest parity during the financial market turmoil of 2007–08:
This paper investigates the spillover effects of money market turbulence in 2007–08 on the short-term covered interest parity (CIP) condition between the US dollar and the euro through the foreign exchange (FX) swap market. Sharp and persistent deviations from the CIP condition observed during the turmoil are found to be significantly associated with differences in the counterparty risk between European and US financial institutions. Furthermore, evidence is found that dollar term funding auctions by the ECB, supported by dollar swap lines with the Federal Reserve, have stabilized the FX swap market by lowering the volatility of deviations from CIP.
Our finding bears similarities with the Japan premium episode in the late 1990s. At that time, due to a substantial deterioration of their creditworthiness relative to that of other financial institutions in advanced nations, Japanese banks found it extremely difficult to raise dollars in global money markets, and a so-called Japan premium arose between dollar cash rates paid by Japanese banks and by other banks (Covrig, Low, and Melvin 2004; and Peek and Rosengren 2001). As suggested in Nishioka and Baba (2004) and Baba and Amatatsu (2008), Japanese banks then turned to the FX swap and longer-term cross-currency markets for dollar funding, which resulted in substantial deviations from the CIP condition in its traditional sense. The dislocations in the FX swap market that have been triggered by the turmoil may be understood in a similar context.
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finding is consistent with the view that the demand for dollar liquidity in FX swap markets under the turmoil came from a wider array of financial institutions than just dollar Libor panel banks. A similar observation can be made for the Libor-OIS (euro-dollar) variable: it always has a significantly positive effect on the FX swap deviation under the turmoil but not so in all cases before the turmoil. The estimated coefficients during the period of turmoil are larger, more significant, and closer to the value of 1 suggested by the earlier decomposition (equation (3)). This is consistent with the view that relative liquidity conditions in the Libor funding markets mattered more to FX swap markets during the turmoil than before.
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This paper has empirically investigated spillovers to the FX swap market from the money market turbulence that began in the summer of 2007. As documented in Baba, Packer, and Nagano (2008), an important aspect of the turmoil was a shortage of dollar funding for many financial institutions, particularly European institutions that needed to support US conduits for which they had committed backup liquidity facilities. At the same time, financial institutions on the dollar-lending side became more cautious because of their own growing needs for dollar funds and increased concerns over counterparty risk. Facing these unfavourable conditions in interbank markets, non-US institutions turned to the FX swap market to convert euros into dollars.
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Our empirical results show a striking change in the relationship between perceptions of counterparty risk and FX swap prices after the onset of financial turmoil. That is, CDS spread differences between European and US financial institutions have a positive and statistically significant relationship with the deviations from [Covered Interest Parity] observed in the FX swap market. The result holds when we consider the CDS spreads of a range of financial institutions wider than that of the Libor panel. Our findings suggest that concern over the counterparty risk of European financial institutions was one of the important drivers of the deviation from covered interest parity in the FX swap market.
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While not significantly reducing the level of FX swap deviations over the period, the ECB’s US dollar liquidity-providing operations to Eurosystem counterparties do appear to have lowered the volatility (and thus the associated uncertainty) of the FX swap deviations. Our estimation results thus support the view that the dollar term funding auctions conducted by the ECB, supported by dollar swap lines with the Federal Reserve, played a positive role in stabilizing the euro/dollar FX swap market.This study covers a period that ends in September 2008 shortly before the bankruptcy of Lehman Brothers. After the Lehman failure, the turmoil in many markets become much more pronounced. In currency and money markets, what had principally been a dollar liquidity problem for European banks deepened into a phenomenon of global dollar shortage. The provision of dollar funds by central banks, supported in some cases by unlimited dollar swap lines with the Federal Reserve, expanded greatly. One promising line of research would focus on the effectiveness of the diverse array of policy measures taken in this recent, more severe stage of the financial crisis.