Covered interest parity (CIP) is a fundamental no-arbitrage principle in international finance, stating that a currency’s forward discount should equal the interest rate differential between two currencies. When CIP holds, borrowing and lending across currencies with proper hedging should yield no arbitrage opportunity. However, significant deviations from CIP have been observed among G10 currencies since the 2007-08 Global Financial Crisis, attributed to tighter balance sheet constraints faced by financial intermediaries.
A recent study challenges the notion that post-Global Financial Crisis CIP deviations are exceptional. Using a newly assembled dataset covering 19 advanced economy currencies from 1963 to 2025, researchers found that substantial CIP deviations have been the norm over the last six decades. The minimal deviations observed just before the Global Crisis were the exception. The study ruled out capital controls and higher transaction costs as explanations, as deviations were equally frequent and large pre- and post-crisis, except during 2000-2006.
The study argues that financial intermediary frictions, such as balance sheet constraints and regulatory changes, explain the long-run presence of CIP deviations. Banking regulations tightened and loosened over time, affecting intermediaries’ ability to arbitrage. The years 2000-2006, when CIP held closely, coincided with relaxed regulation and a global credit boom. The study also highlights the role of financial intermediaries in linking US dollar money markets and synthetic funding markets, absorbing imbalances.