Publications
Publications
- 2016
Credit Migration and Covered Interest Rate Parity
By: Gordon Y Liao
Abstract
I document economically large and persistent discrepancies in the pricing of credit risk between corporate bonds denominated in different currencies. The discrepancies amount to 50-100 basis points on trillions of dollars of debt notional. I relate this violation of the Law-of-One-Price (LOOP) in credit markets to violations of covered interest rate parity in the foreign exchange (FX) market. The two seemingly unrelated LOOP violations are closely aligned in the time series and the cross-section of currencies. I develop a model in which LOOP violation and limits of arbitrage in one market spill over to the other market. To integrate the pricing of credit risk of corporate bonds denominated in different currencies, cross-market arbitrageurs have to walk down a downward-sloping demand curve in the FX forward market. These cross-market arbitrageurs are either firms with currency-hedged foreign debt issuance or investors with currency-hedged investments. Post-crisis regulatory restrictions and intermediary frictions have severely hindered arbitrage in the FX and credit markets each on their own, but capital flows bundle together the two LOOP violations. I test the model predictions using data on cross-currency debt issuance flows. Arbitrageable profit, represented by the difference between the two deviations, explains a significant fraction of cross-currency corporate debt issuance flow.
Keywords
Market Segmentation; Debt Issuance; Covered Interest Rate Parity; Cross-currency Basis; Credit Risk; Financial Markets; Credit
Citation
Liao, Gordon Y. "Credit Migration and Covered Interest Rate Parity." Working Paper, October 2016.