Offshore Dollar Funding Shocks and the Dollar Exchange Rate
Abstract: Deviations from covered interest rate parity (CIP) have persisted since the global financial crisis, reflecting a segmentation between onshore (U.S.) and offshore dollar markets. This segmentation can give rise to dollar shortages in offshore markets during periods of financial stress. We propose a model with limited CIP and UIP arbitrage where the CIP deviation and exchange rate are jointly determined by equilibrium in the swap and spot FX markets. We consider offshore dollar funding shocks, where either the supply of dollar funding by the U.S. to offshore markets declines or the demand for dollar funding in offshore markets rises. We show that this gives rise to dollar shortages, with a rise in the CIP deviation and appreciation of the dollar. In contrast to other models of exchange rate determination, the dollar appreciation is entirely due to imperfect CIP arbitrage.
DOI: https://doi.org/10.24149/gwp425r2
Appendix DOI: https://doi.org/10.24149/gwp425appr2
Revision 1
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