Covered Interest Parity Deviations: A Dive Into One of Modern Time’s Financial Puzzles

Abstract

The Covered Interest Parity (CIP) has held for several decades and has been a core assumption in financial markets. The parity is a no-arbitrage condition which states that the implied interest rate in the foreign exchange market should equal interest rate in the cash market. However, over the last decade, this parity has been persistently violated, and a theoretical arbitrage opportunity has been allowed to flourish broadly. This thesis aims to identify the drivers for the widening of the basis and why it has yet to close for the GBP. In an effort to do so, we look at the existing research and identify the key variables for their theories. Through an individual analysis of each variable and regression analysis, we find evidence that supports several of these theories based on data from 2010 to March 2019. We are unable to explain the majority of the daily moves in the basis against GBP, especially in the more volatile period of 2015-2019, however, our findings should be useful for further research on the subject.