Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

MSc in Finance & International Business, Thesis Department of usiness Studies Author: !eynep "uyucu Supervisor: Morten alling

Turmoil in the International Interbank and FX Swap Markets: theories, parit condition, polic matters and risk mana!ement

Aarhus School o" Business, #niversit o" Aarhus September $%%&

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Abstract The object of this study was to evaluate the tension in the international interbank and foreign exchange markets during the recent financial turmoil, 2007-2009 !nformation was mainly extracted from recent articles with newest "ossible data, #ank of !nternational $ettlement, and key central banks !n order to analyse the tension in the interbank markets by factors as credit and li%uidity risk have been em"hasised, whereas the analysis of the foreign exchange swa" markets, the covered interest "arity &'!() set forth by *eynes &+92,) in his Tract on -onetary .eform, and further elaborated by Tsiang &+9/9) has been a""lied 0rder to ex"lain the widened s"reads in the 1ibor-0!$, unsecured and secured along with term rate s"reads, credit default swa"s &'2$), foreign exchange swa" im"lied dollar rates, through factors such as credit risk, li%uidity risk, market li%uidity, funding li%uidity The em"irical framework was analysed and discussed according to the a""lied theories !t was concluded that, in "articular after the 1ehman brothers default there has been a heightened s"reads in both markets Thus, after the central banks interventions, there has been observed a more release in the market, though credit risk has been reduced along with the intervention of fiscal authorities Thus, it is necessary to identify the underlying dynamics, in order to a""ly the correct tools to reduce the market turmoil

Keywords: Turmoil in international interbank and 34 swa" markets, credit default risk, li%uidity risk, funding risk central bank and fiscal authorities5 interventions

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

67eorge #ernard $haw once remarked that the lack of money is the root of all evil 8hile this is clearly an overstatement, there have been "eriods, like the 7reat 2e"ression of the +9,0s, for which the statement rings true #ut there have also been numerous e"isodes in history in which too much money as been the root of all evil# $loyd % Thomas

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Table o" )ontent
&'()T*+ ,: I-T+.D/&TI.-%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%0 &'()T*+ 1: Theoretical Frameworks%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%,2 &'()T*+ 3: rief Summary of *4ents leading to the crisis in the Interbank and FX Swap Market%%%%%%%%%%%%35 &'()T*+ 2: Descripti4e Statistics%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%30 &'()T*+ 0: *M)I+I&($ (-($6SIS 7 DIS&/SSI.- %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%02 &'()T*+ 8: (nalysis and Discussion of the &entral anks Inter4entions%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%89 &'()T*+ :: &'()T*+ :: )*+S)*&TI;*%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%95 &'()T*+ <: &'()T*+ <: &.-&$/SI.-%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%93 &'()T*+ 9: ibliography%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%9:

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

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69ow could this ha""en: ;o one thought that the financial system could colla"se $ufficient safeguards were in "lace There was a safety net< central banks that would lend when needed, de"osit insurance and investor "rotections that freed individuals from worrying about the security of their wealth = IS =155<>:9th?: 2>0?% This abo4e stated @uotation has been a concern for the whole world economy% (s a result it has been announced that the world economy has been positioned in the worst recession, since the Second Aorld Aar, =Danmarks -ationalbank =1559?: ,?% The deterioration in the /S subprime mortgage sector that surfaced in the summer of 155: rapidly spilled o4er to other segments such as the international interbank and FX swap markets% Since then the financial markets, in particular the core money markets ha4e been characterised by turmoil =Danmarks -ationalbank =155<a?: ,,?% Interbank markets are percei4ed as among the most important markets in the financial system, as they focus of central banksB implementation of monetary policy and ha4e a significant effect on the whole economy =(llen and &arletti 155<?: ,?, while the FX swap markets one of the most li@uid markets =*& =155:?: 18?% (s mentioned in the abo4e @uotation, gi4en these features of these markets, the financial system collapsed% )oorly functioning money markets impinges on the a4ailability and cost of credit to businesses and households, and eCpose the effecti4eness of monetary policy =Taylor =155<?: 1?% It is therefore, essential to eCamine the underlying factors that ha4e caused this dysfuntioning in these core markets, in order to be able to shelter from any similar future financial turmoil% The paper is organised as follows% In chapter one, the problem statement, delimitation 7 assumptions, definition, abbre4iation, source critics and methodology is presented% &hapter two presents the essential theoretical frameworks, and in chapter three a brief summary of e4ents leading to the crisis that surfaced in the international interbank and FX swap markets% &hapter four describes the statistical data and basing the argument on the eCisting empirical literature, and chapter fi4e represent the empirical analysis and discussion behind the underlying factors for the
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*conomists identify these # ig 0# crises since AA II =out of ,< total? Spain '&22: The first energy crisis affected SpainDs banking system, leading to 01E of ,,5 banks into serious problems% ,orwa '&32: &ommodity> shock dri4en recession led to losses and the insol4ency of banks: three largest banks nationaliFed% Finland '&&': +ecessions preceded by financial market liberaliFation and the collapse of eCports to the former So4iet /nion led to a se4ere depression: the Finnish go4ernment spent o4er ,5 billions *uros o4er the crisis period to support Finnish banks% Sweden: ( restructuring of the taC system caused financial bubble that formed during ,9<5s to burst: the central bank unsuccessfully to defend the currencyDs fiCed eCchange rate with the interest of 055E 4apan '&&$: -on>disclosure and a lack of transparency resulted in lower rating of Gapanese financial institutions: thirteen Gapanese financial institutions went effecti4ely bankrupt during ,990 =.einhart and .ogoff, &200>))

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management tension% Finally, chapter siC analyse and discuss the central banks enrichments of the problem statement along with fiscal authoritiesD inter4entions% &hapter se4en contains the perspecti4e and chapter eight the conclusion% 1.1 Problem statement

63inancial crisis dee"ened in $e"tember 200>, li%uidity in the interbank market has further dried u" as banks "referred hoarding cash instead of lending it out = 'eider et al =1559?: ,?% (s a resulted the turmoil 6s"illed over through the short-term foreign exchange &34) swa" market6 = aba =1559?: 12?% Despite FX 6markets a""ear to have increased in efficiency over time "rofitable arbitrage o""ortunities do tend to arise during "eriods of uncertainty and turbulence and may "ersist for some time before they are arbitraged away= =Taylor =,9<9?: 3<8?% $ately, the lack of li@uidity in the international interbank market has been a great discussion issue along with the financial crisis% In order to understand, the turmoil the international interbank market has been positioned in, and which spilled o4er to international FX swap markets, it is 4ery essential to in4estigate what caused the financial system to break down to the eCtent it has in the time period of summer 155: and 1559% Therefore, this paper aims to eCplore the factors behind the tension in the international interbank and FX swap markets and the central bank inter4entions that ha4e occurred subse@uently% This paper will co4er the presented proposal, attempting to pro4ide clear and coherent answers% This thesis follows the frame of the chronological maHor e4ents of the financial turmoil beginning in the interbank market in the summer 155:, followed by the inter4entions of the central banks and thereby the spill o4er of the turmoil to the foreign eCchange swap markets% The thesis is di4ided into four main parts, the first part of the paper will co4er the theoretical framework of the effect of the turmoil in the interbank market% That is to identify the risks in the international interbank market that ha4e pre4ailed the recent turmoil i%e% to in4estigate credit risk theory i%e% how many types of credit risks eCistI 67iven the im"ortant role of ratings in the investment and risk management "rocesses, and in regulation, the turmoil has also raised %uestions about the effectiveness of credit rating agencies5 &'.?s5) assessments of risks in rating com"lex financial "roducts= = IS =155<?: ,?% Thus, it will be identified what the greatest three credit rating agenciesI Ahat are the rating categories presented by these credit agencies related to collateral and uncollateralised interbank instrumentsI 0n what reasons are the credit ratings based on:

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Moreo4er, what is li@uidity riskI Ahat are the types of li@uidity risk in the financial marketsI (nd what are underlying factors li@uidity risk depends onI Furthermore, the thesis will bring light to the theoretical framework of the FX swap market% It will analyse what the co4ered interest arbitrage and what co4ered interest rate parity condition =&I)?s are I Furthermore, it will eCamine the link between the &I) and the FX Swap markets% The second main obHect of the thesis is to describe the problem statement with possible statistical data eCplanation factors behind the tension obser4ed in the international interbank and FX swap markets% Therefore, the first part of the second main part of the thesis, initially intends to describe the fundamental characteristics of the international interbank markets% Ahat is the interbank marketI 'ow does this market functionI Thereafter, the de4elopment in the international interbank through measures reflecting the theoretical framework i%e% how did the $ibor>.IS spreads, secured and unsecured spreads along with term rate spreads, credit default swap =&DS? spreads de4eloped in the /S interbank market, *uropean interbank market, /" interbank market and =Gapanese market?, during the time period of 155:>1559%This will be followed by a description of the FX swap market i%e% what is the FX swap marketI 'ow does the FX swap market functionI (nd again the de4elopment of the FX swap implied dollar rates% The third part of the thesis will empirically analyse and discuss the statistical data obser4ed in the second main part, in the light of the applied theories% Ahat triggered lack of li@uidity eCperienced in the international interbank marketI Ahat was the relation between the interbank market and the li@uidity facilities of the central banksI Ahat were the underlying dynamics behind the tension in the international interbank marketsI (gain, what triggered the spill o4er to the FX swap marketI Ahat was the underlying reason behind the FX swap spread i%e% de4iation of co4ered interest parity =&I)? obser4ed in part two% Furthermore, there will be an in4estigation of the central bank responses along with fiscal authoritiesD inter4entions during the financial turmoil in the international interbank and FX swap markets% Ahat ha4e the main central banks implemented as a response to the financial crisisI 'a4e these actions been able to eliminate the tensions obser4ed in part 1 i%e% credit and li@uidity riskI Ahy ha4e go4ernments inter4ened in the crisisI Ahat are the most remarkable actions by these go4ernmentsI

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management (nd finally, the fourth part of the thesis presents the perspecti4e and the conclusion% There will be a re4iew of how to weather such a future financial crisis in the international financial markets through new regulations% 1.2 Delimitation & Assumptions

The (nalysis of the tension in the international interbank and foreign eCchange =FX? swap markets presented in this paper is based on certain assumptions and certain factors which are delaminated, that are discussed below% Though, assumptions and delimitation can also occur through the paper, where it is seen necessary for the sake of a more clear understanding% This paper is founded primarily on the most se4ere effected marketsJcurrencies in the K>,5 markets i%e% the /S dollar, *uro, Sterling markets% This relies in the reasoning of eCtended a4ailable information on these groups as recent maHor researches ha4e been conducted in this study area =Michaud 7 /pper =155<?: 2:?L aba et al =155<?: :2?L *& =1559>,510?: 9>,,?% 'ence, order to gi4e a better understanding comparison to other markets such as the (sian markets i%e% Gapanese market canJwill occur to present a more accurate picture of the effect of the international money markets and FX swap markets% 'owe4er, technicalities and legal niceties will not be elaborated and therefore ignored in this thesis =Stigum =155:?: ,,5,?% Moreo4er, in this paper, banks are used as a generic term for the central banksB counterparties =Danmarks -ationalbank =155<>,?: 21?% The central banks that will be referred to in the thesis will be mainly Federal +eser4e ank, *uropean &entral ank, and ank of *ngland% 'ence, in order to gi4e a more comprehensi4e 4isual rendering of the global financial turmoil, other central banks that ha4e played a central role in the crisis will also be included i%e% for instance the Swiss -ational bank, ank of Gapan, and ank of &anada% Interbank markets are subHected to a wide array of risks in the course of their operations =Krabbe =,998?: 11:?% In general, banking risks fall into four categories i%e% financial, operational, business and e4ent risks% Financial risks comprise two types of risk i%e% pure risks and speculati4e risks% First, pure risks, includes li@uidity, credit and sol4ency risks, and secondly speculati4e risks, which in4ol4es interest rate, currency and market prices risks =;an Kreuning =1553?: 3?% Ki4en that the interbank market is also in4ol4ed in foreign eCchange, as well as ordinary time deposit rates etc% it is also eCposed to credit, currency, and li@uidity risk as in general banking =Kallanis =1559?: 8,?% 'ence, as the main subHect of this paper is to in4estigate the creditJli@uidity risks in relation to the global financial crisis in the international interbank and FX swap markets, this paper will solely focus on credit and li@uidity risk% The other mentioned risks will not be delimitated due to the scope
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management of the paper and limited paper siFe% Furthermore, there will solely be focus on the greatest three eCternal agencies i%e% S7)Bs, MoodyBs and Fitch, and their short term credit ratings, as this paper simply in4estigates the short term international money markets =&rouhy =155,?: 18,?L (shcraft 7 Schuermann =155<?: 3:>3<?% (s the aim of the paper to in4estigate the short term international interbank markets, thus, in this paper, solely instruments with maturities within one year% Those that will be included are issued by financial corporations and go4ernments to obtain short term funds =Madura =1555?: ,10?% These instruments are further characteriFed by 6high li%uidity and relatively low default risk= =$loyd =,99:?: 01?, which is a @uite important aspect for the recent financial turmoil in the international money markets% These instruments will further be distinguished between unsecured and secured instruments, where unsecured instruments that will be included is interbank loans, and secured instruments as bankers repurchase agreements =repos? =.*&D =155:?: 291?% Furthermore, as a FX eCchange instrument, there will solely be focus on FX swaps aba et al% =155<?, which also are secured instruments due to the international aspect of the paper =Mehlbye 7 Topp=,998? :29?% 1.3 Definitions & Terminology

In this subsection, the 4arious definitions used in the paper will be presented, in order to eliminate any ambiguity that could rise due to differences in terminology% 'overed !nterest (arity 'ondition< In the literature, there has been a miCture of use of the co4ered interest =rate? parity condition =)eel and Taylor =1551?: 01?L "eynes =,913?: ,53>,52?L *aton and Turno4sky =,9<3?: 000?, while other authors ha4e used the term interest parity condition, which also is the non arbitrage condition, to describe the latter Da4id et al% =,99<?L 'illey =,9:9: 99?L Tsiang =,909?: <,? as it is assumed it is co4ered% Therefore, in this thesis both of the terms are consistently applied with the obHecti4e of eCplaining the same condition% !nternational -oney -arket< $e4inson =1550? emphasises that there eCists no precise definition of the money markets but the phrase is usually applied to the buying and selling of short term debt instruments The money market is further described as a network of corporationsD i%e% financial institutions, in4estors and go4ernments which deal with the flow of short>term capital 1 =$e4inson =1550?: 3<>39?, Madura =1555?: 1?L $loyd =,99:?: 01?% Money market instruments are issued when
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That is when businesses need cash for few months until a great payment arri4es, or when a bank wants to in4est money that depositors may withdraw at any time, or when a go4ernment tries to meet its payroll in the face of large seasonal fluctuations in taC receipts, short term li@uidity transactions =$e4inson, Marc =1550?: 3<>39?, =Geff Madura =1555?: 1?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management e4er eCperienced a temporary shortage of cash, and due to the fact that money markets ser4e businesses, the a4erage transaction siFe is 4ery large =Madura =1555?: ,3:?% There are se4eral types of money market instruments3 which are issued in the primary market 2 by corporations and go4ernments to obtain short term funds through sale in the secondary market =Madura =1555?: ,10?, =$e4inson =1550?: 21?% .ne of the 4ery important instruments is interbank loans, which are traded in one of the money market segment called interbank market% .*&D =155:? defines the international interbank market as the followingL 6The international interbank market is an international money market in which banks lend to each other @ either cross-border or locally in foreign currency @ large amounts of money, usually for "eriods between overnight and six months= =.*&D =155:?: 2,,?% The definition created by .*&D will be applied as it defines it clear and shar", and the aim of this thesis to in4estigate the international interbank market due to the detected recent turmoil in there% In the thesis the term interbank market is applied as international interbank market, eCcept an eCplicit interbank market is gi4en% Thus, the short term instrument maturities can be eCtended to ,1 months% 'ollateraliAed 2ebt 0bligation &'20)< ( &D. is a type of asset backed security, a financial tool that repacks indi4idual loans into a product that can be sold on the secondary market% The portfolio of the underlying of the &D. can consist of bank loan, corporate bond etc% &D.Bs are called asset> backed commercial paper, if the package consists of corporate debt, and mortgage backed securities, if the loans are mortgages% If the mortgages are made to those with a less than prime credit history are called subprime mortgages =)lesner =1550>1?% 3orward exchange rate< The forward eCchange rate in this paper will be eCpressed as the unit price in local currency of foreign eCchange bought or sold for future deli4ery% Ahile the forward premium =or discount when negati4e? is to be understood as the discrepancy between the forward and spot eCchange rates as percentage of the spot eCchange rate =Tsiang =,909?: :8?% $i@uidity #is easier to recogniAe than to define= = oF =155<?: I?% ;arious authors ha4e defined this notion% ;ery broadly, li@uidity has been defined as ability of payment, or more accurately defined by the Federal +eser4e
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ank as the 6The ca"acity and the "erceived ability to meet known near-

See (ppendiC ,, for the most known money market instruments% The primary market is referred to the initial offering of a security i%e% whether a stock, a bond, a loan, or a deri4ati4e instrument% Ahile the secondary market refers to the market where eCisting securities can be traded between in4estors =(r4ind =,992?: ,88?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management term and "rojected long-term funding commitments while su""orting selective business ex"ansion in accordance with the bankBs strategic "lan= =)lesner =155<?: 2?L asel "omittee =1555?: ,?% 6et, IS =,999?, also highlights and defines a li@uid market as a market where participants can @uickly eCecute large 4olume transactions with a small impact on prices = IS =,999?: 0?L oF =155<?: I?% The referred *uropean System =of &entral anks? consists on the *uropean &entral ank =*& ?

and the national central banks of the *uropean /nion member states% It is to be noted that the national banks of those Member States, which ha4e not adopted the single currency in accordance with the Treaty establishing the *uropean &ommunity are not in4ol4ed in the conduct of the single monetary policy, due to retain in own monetary policy according to national law =*& =155<t?: :?% 1.4 Choice of Metho

The thesis intends to assess the underlying dynamics behind the turmoil in the international interbank and FX swap markets% The thesis is a theoretical paper ne4ertheless rele4ant a4ailable empirical studies will be incorporated, order to enlighten the theoretical framework from a practical point of 4iew% In order to create a connection between the tension eCperienced in the international interbank and FX swap markets, credit and li@uidity risk theories and the co4ered interest rate parity theory will be re4iewed% The academic literature on credit risk has grown substantially o4er the last decades% Modern techni@ues and models0 ha4e been de4eloped to assist financial intermediaries, corporate and in4estors to better price and manage the credit risk eCposure they are facing% 6et, in this thesis, these maHor models will not be touched further as it is out of the scope of this paper% 'ence, credit risk presented by ank of International Settlement, Kallanis =1559?, and 'orcher =1550? will be described with the simply aim of enlightening the effect of the credit risk on the international interbank and FX swap markets% Simultaneously, li@uidity risk theory presented mainly by runnermeier 7 )edersen =155<?, )lesner =155<?, and ank of International Settlement will be re4iew% Ahereas, the analysis of the foreign eCchange swap markets is based on the co4ered interest
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Three main approaches to analyFing credit has been presented i%e% the structural, reduced form and incomplete information approaches =FaboFFi, =1550?: :<5?% The structural credit models, goes back to the lack and Scholes and Merton =,9:3? which relied on the use of the option theory framework to model the 4alue of the e@uity of the firm and corporate debt% The market 4alue of the firms appears as an essential source of uncertainty dri4ing the credit risk =FaboFFi%=1550?: :<5?% The other line of literature in4ol4es the alternati4e for modeling credit risk from the structural approach is the reduced form% Garrow 7 Turnbull =,990? and Duffie and Singleton =,999? ha4e presented two recognised models under this framework =Garrow 7 Turnbull =,990?:03?, =Duffie and Singleton =,999?: 8<:?% In this approach, the reason behind the default of a firm is not answered, but instead the dynamics of default are gi4en eCogenously through a default rate% The third approach combines the structural and reduced form model, where a4oiding the two other approaches difficulties, it chooses the best features of both approaches% I%e% the economic and intuiti4e appeal of the structural approach and the tractability and empirical of the reduced from approach% In this approach, prices of credit>sensiti4e securities can be calculated as if they were default>free using an interest rate that is the risk free rate adHusted by the intensity =Garrow 7 Turnbull =,990?:02?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management rate parity =&I)? set forth by "eynes &+92,) in his Tract on -onetary .eform, and further elaborated by Tsiang =,909?% *ach of these two markets will be described and the de4elopment of the tension will be described in the following measuresL $ibor>.IS spread, secured and unsecured term rates, &DS spreads and FX swap implied dollar rates will be described, which aims to connect the theoretical frameworks with the statistical data a4ailable, as the theories will be reflected in these measurements% Furthermore, in the fourth part of the thesis there will be a discussion of the underlying dynamics behind the measurements in the light of the applied theoretical framework% This will be followed by an analysis of the central banks actions and the effecti4eness of the applied inter4entions along with the fiscal authorities% 1.! "ource Critic

Due to the nature of the study subHect i%e% to analyse the international interbank market and the financial turmoil it is weathering, it is @uite important to gather as much information as possible to be able to gi4e a fair portrait% Thus, this paper is founded on a great range of litterateur which is financial, economic and empirical% Moreo4er both international and Danish litterateur will be applied to illustrate 4arious perspecti4es as possible, in the frame of the problem statement% Moreo4er, it has to be stated that a maHor part of the data is eCtracted from loomberg 8, and (arhus school of usiness do not ha4e access to this website, therefore, the maHor set of data collected is from sources such as prominent authors that ha4e engaged in the field and maHor central banks, as *uropean &entral ank, Federal +eser4e ank, ank of *ngland, ank of France stability reports, and bulletins Therefore, the applied sources are percei4ed to be highly reliable% The Hudgements on the data are based on the latest possible sources after eCamined carefully and compared to the maHority of the data due to clear and cohort answers% 'ence it cannot be reHected that the data applied are based on 4arious time Fones, and do not co4er eCactly the time frame from the second half of 155:, and until 1559 due to limited a4ailability% It should be noted that while e4ery effort has been taken to make this paper as accurate as possible, changes in statistics, legislations or other factors may mean that some 4ariation could occur and a result of this it may not be 4ery comparable%

This has been confirmed by Mr% -aohiko aba and &hristian /pper with an email, stating that loomberg has been a key source of origin in data collecting, both for $ibor>.IS, &DS, and FX swap implied dollar rates spreads applied in chapter 2% = aba =1559?: ,< (ugust?L /pper =1559?: ,< (ugust?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management (dditionally, both empirical and other articlesJpublications that enlighten the study subHect are applied% &oncerning the empirical articlesJpublications applied, there has been attempt to rely on authors who ha4e specialised in the subHect range% .thers ha4e been selected based on the publishers who are percei4ed to be trustworthy% Moreo4er, press releases with prominent characters associated with the problem statements is also attempted to be applied% These are found from websites, which are assessed credible% In the selection of empirical studies, it has been crucial whom the studies ha4e been conducted by% Thus, there ha4e been applied empirical studies also made by the abo4e mentioned central banks, as many ha4e been conducted by these as well, as it is crucial for the problem statement of this paper% 'owe4er, the selection criteria for the studies ha4e been based on latest time being, at the same time as could enlighten the theoretical frameworks from a more practical point of 4iew% It cannot be redundant that some of the empirical studies ha4e been conducted on different time frames, which will of course not gi4e the same comparison basis for the applied empirical data% The data and years will be mentioned on e4ery occasion it is seen rele4ant% 1.# Abbre$iations (sset> acked Securities (sset> acked &ommercial )aper ank for International Settlements ank of &anada ank of *ngland ank of Gapan &ollateralised Debt .bligations &o4ered Interest (rbitrage &o4ered Interest +ate )arity *uropean &entral ank Federal +eser4e The /S Federal .pen Market &ommittee Foreign *Cchange The +eser4e ank of (ustralia Mortgage> acked Securities Structured In4estment ;ehicle The Swiss -ational ank Term Securities $ending Facility )rimary Dealer &redit Facility

( S ( &) IS o& o* oG &D. &I( &I) *& Fed F.M& FX + ( M S SI; STS$F )D&F

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

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There eCist 4arious reasons for the spill o4er effect of the turmoil to the foreign eCchange swap markets, initiating from the interbank market% Therefore, this section aims to co4er the theoretical aspects of the effect of the turmoil initially detected in the interbank market i%e% the credit> and li@uidity risk theories, which will be the basis for the second part of the theoretical framework% The second part of the first part of the paper will bring light to the theoretical framework of the FX swap market i%e% the co4ered interest arbitrage condition =&I(? and co4ered interest parity condition =&I)?, and the relation to the FX swap market% Part %& Interbank markets are subHected to a wide array of risks in the course of their operations =Krabbe =,998?: 11:?% Financial risk is one of these risks mentioned abo4e and comprise of inter alia pure risks, which includes li@uidity and credit risks% =;an Kreuning =1553?: 3?% (ccording to se4eral authors, gi4en the nature of the interbank markets, this market is eCposed to credit and li@uidity risk as in general banking =Kallanis =1559?: 8,?% Thus, this chapter aims to gi4e a description of the theoretical framework of credit and li@uidity risks which ha4e played central roles in the recent financial turmoil identified in the international money markets% 2.1 Cre it 'is(

68ould you lend your money to this:= This hoary @uestion has been asked by loan pro4iders, in4estors, and credit analysts all o4er the world as an assessment of the commitment of the one =Kanguin, laise =1552?: ,:?% *4ery business face credit risk as it eCists whene4er payment or performance to a contractual agreement by another entity is eCpected, and it is the likelihood of a loss arising from default or failure of another entity% &redit risk is defined as the 6'redit risk is most sim"ly defined as the "otential that a bank borrower or counter"arty will fail to meet its obligations in accordance with agreed terms= = IS =,999?: ,?L +eto =1553?: ,35?L anks =1552?: 8?% In particular, financial institutions generally ha4e considerable credit eCposure due to their prominence on lending and trading ='orcher =1550?: ,53?, and the international interbank market is not an eCception% (ccording to (ikman =155<?, interbank markets are subHect to types of risk i%e% borrower default and market risk, which will be discussed in details below =(ikman =155<?: <?% (ccording to (nson et al% =1552? credit risk is specified as three types of risk i%e% default, downgrade and credit risk =(nson et al% =1552?: 2?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management 2efault .isk< 'orcher =1550? stresses that, traditionally, credit risk is associated with lending, in4esting, and credit granting acti4ities and concerns the return of borrowed money% 'owe4er, a great source of credit risk in financial markets arises from the performance of counterparties in contractual agreements e%g% gi4en a financial obligation, which is not fully discharged, either due to the counterparty disability to fulfil his or her obligations which may result in a loss% In the literature, these credit risks are referred to as counterparty risks since they arise from transactions with counterparties ='orcher =1550?: ,52>:?% 6et, according to (nson et al% =1552? counterparty risk is defined as default risk, where the issues of a bond or the debtor on a loan would not replay the outstanding debt in full% Default risk can be complete gi4en that no amount of the bond or loan would be repaid or partial, gi4en that some part of the original debt would be reco4ered =(nson et al% =1552?: 13?% The likelihood of the default occurring is recognised as the probability of default% The likelihood of a reco4ery depends on se4eral factors as well as the legal status of the creditor, hence if an institution fails due to large outstanding obligations or losses, later collections may be difficult or impossible ='orcher =1550?: ,52>0?% 2owngrade .isk< In order to estimate the default risk, in4estors rely on credit analysis conducted by nationally recognised statistically rating firms, which eCpress their estimates in the form on credit rating: =(nson =1552?: 13?% The following subsection will further elaborate on the main three credit rating agencies% Downgrade risk is thereby defined as the risk that a recognised rating firms such as Standard 7 )oorBs, MoodyDs In4estors Ser4ices, or Fitch +atings reduces its outstanding credit rating for an issuer based on an e4aluation of the current earning supremacy of the issuer in opposition to its capacity to repay its debt obligations as they become due% (n impro4ement in the credit @uality of an issue or issuer is rewarded with a superior credit rating, referred to as an upgrade, whereas a weakening is referred to as a downgrade =(nson =1552?: 2?% The conse@uences of a downgrading of a credit rating will depend on the following circumstancesL the market price of the debt securities will fall, and thereby in4estors will suffer a loss% If the issuer prepares to issue more debt securities, in4estors will demand a higher rate of interest to compensate for the higher risk% In some situations, the issuer may agree to a condition whereby the interest
:

(lthough credit ratings are pro4ided for the benefit of in4estors, the issuer bear the cost in4ol4ed as it is the interest of the issuer to re@uest a rating as it raises the profile of the issue of debt capital, and in4estor may refuse a purchase that is not accompanied with a recognised rating% In theory, credit rating is not applied to an organisation itself, but to a particular debt security that the firm has issued% 'ence, in general practice it is common for the market to refer to the creditworthiness of firm itself, in terms of the rating of their debt% *%g% a highly rated firm may be referred to as a Mtriple ( rated#, although it is the debt issues of the company that are rated as triple ( =(nson =1552?: 13?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management payable on the securities to be raised if their credit rating is downgraded to or below certain le4el =&oyle =1551?: ,32?% 'redit $"read .isk< ( credit loss may occur i%e% the credit standing of the issuer is percei4ed by the market to ha4e diminished% The market will subse@uently re@uire an interest rate premium i%e% a higher credit spread? to co4er the higher credit risk forcing the security price to drop% ( wider credit spread could also reflect the perception of the market that the return on a security with a gi4en credit @uality must be higher, e%g% in association with a repeated downturn =Danmarks -ationalbank =1553?: 98?% Therefore, credit spread risk is the risk that the spread o4er a reference rate would increase for an outstanding debt obligation% The difference between credit risk and downgrade risk is that the latter concerns a particular formal credit re4iew by an independent rating agency, whereas the former is the reaction to percei4ed credit weakening of the financial markets =(nson, Mark =1552?: 0>8?% 'orcher =1550? presents 4arious factors that could be presented as an eCplanation for this disability i%e% poor economic conditions, high interest rates, or when an organisation has accumulated large losses, owes many other counterparties, or when a creditor or counterparty of an entity face financial difficulty or failure ='orcher =1550?: ,53>2?% $:':' )redit 0atin! A!encies 67iven the im"ortant role of ratings in the investment and risk management "rocesses, and in regulation, the turmoil has also raised %uestions about the effectiveness of credit rating agencies5 &'.?s5) assessments of risks= = IS =155<?: ,?% If someone is willing to in4est their own money, then they would most probably ha4e conducted a full due diligence analysis, screening all assumptions and 4erifying the related facts% (nyone who has the responsibility for lending the money of an institution to another institution should ha4e the same le4el of analytical commitment% Information is often 4aried and imprecise, it is preeminent to ha4e on a tight rein and systematic approach to the task =Kanguin =1552?: ,:?% -e4ertheless for this reasons credit rating agencies ha4e achie4ed a 4ital function as credit risk is dealt with in the interbank market by establishing limits on the amount of dealing with a bank according to the o4erall reputation of the bank in the market =Krabbe =,998?: 135?%

Side '6 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management The asel &ommittee< has become gradually prominent in setting capital ade@uacy guidelines for

banks internationally% In the beginning of 155<, many countries officially adopted #asel !!9% (s a result, the significance of the fundamental credit analysis of financial institutions, the main credit agencies stri4e to pro4ide research to light up the features and ramification of #asel !! =Fitchrating =1559?L Standard 7 )oorBs =1559?L MoodyBs =1559??% Today, the three large credit>rating agencies are Fitch,5, MoodyBs,, and Standard and )oorBs,1 and are regarded as unbiased e4aluators% Their ratings are widely accepted by market participants and regulatory agencies =Danmarks -ationalbank =1553?: 91?L Michel =155,?: 181?% (t the end of ,99:, the number of rated firms was recorded to be 2,555 through the world =(ndersen, et al% =,99<?: 25?, and today, there eCists more than N<5 trillion of rated securities =MoodyBs =1559??% -ethods of 'redit .isk ?ssessment &redit assessments take time and re@uire specialist skills for credit analysts% $arge institutions rely on such specialist to carry out credit analysis, howe4er, too often it is too costly and time consuming =&oyle =1551?: ,31?L (ndersen et al =,99<?: ,?% (ccording to &oyle =1551?, for that reasons in4estor usually employ two methods when making decisions on the credit default risk of debt securities i%e% ,? name recognition and 1? formal credit ratings% -ame recognition is when the in4estor relies on the good name and also the reputation of the issues and accepts that the issuer is of sufficient financial standing, that a default on interest and principle payments is highly unlikely =&oyle =1551?: ,33?% 'ence, it is to be noticed that name recognition needs to be impro4ed by other methods to reduce the risk against surprising e4ents,3% ( credit rating is a formal outlook offered by a rating agency of the credit default risk faced by in4esting in a particular issue of debt securities ,2% -ote that a rating ne4er constitutes a recommendation of the liabilities of a gi4en issuer or borrower, and rating should always be used
8

In ,9:5, K>,5 countries established the asel &ommittee, which is percei4ed as the central bank Ko4ernors of the Kroup of Ten countries =Danmarks -ationalbank =1552?: ,?% 9 In ,9<5 the asel &apital (ccord was published and implemented between ,9<< and ,991, it was the first attempt of the committee to standardiFe the way banks measure and report capital ade@uacy% In ,999, the committee published an impro4ed methodology and measurement of capital in The ;ew 'a"ital ?de%uacy 3ramework, this renamed #asel !! =Fitchrating =1559?% 10 .n 12 December ,9,3, Fitch +atings was founded as the Fitch )ublishing &ompany by Gohn "nowles Fitch% Fitch +atings was one of the three ratings agencies first recogniFed as a nationally recogniFed statistical rating organiFation =-+S+.? by the Securities and *Cchanges &ommission in ,9:0 =www%Fitch%com =1559?%
,,

In ,955, Gohn Moody started its business as the Gohn Moody 7 &ompany )ublished MoodyBs Manual of Industrial and Miscellaneous Securities, which pioneered the MoodyBs +ating as known today =moodys =1559??% 12 S7)Bs is traced back to ,958, where the Standard Statistics ureau was formed to pro4ide financial information on /%S% companies =www%s7)%com =1559??%
,3

In ,990, the ritish bank arings suggested in4estors that relying solely on name recognition was not such a healthy decision in the marketplace of today% The tradition and reputation behind the arings name allowed the bank to borrow at $I .+ or seldom at sub$ibor interest rates in the money market, which made it on par with the highest @uality banks in terms of credit rating =(nson et al% =1552?: 13?% 14 +atings are gi4en to public issues of debt securities by any type of entity, including go4ernments, banks and corporate =&oyle =1551?: ,31?%

Side '2 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management subHect to the in4estor or borrowers own liability and risk =(ndersen et al% =,99<?: ,?% &redit rating, for long term debt obligations, is a forward looking assessment of the probability of default and the relati4e scale of the loss should a default occur% For short term debt obligations, a credit rating is a forward looking assessment of the probability of default =(nson et al% =1552?: 13?L Michel =155,?: 181>83?L Deacon =1552?: ,3?% 'ence, as this paper is solely focusing on short term securities, the focus would only be relied on the credit ratings for short term debt obligations% (ur"ose of 'redit .atings Scoring systems to rank credit risk with grades achie4es se4eral goals, where analysts can benchmark credit @uality across firms from 4arious countries and sectors% (s credit rating will affect the interest rate at which entities can issue new debt securities, or e4en whether they will be able to issue new debt securities, the purpose of the credit rating is to gi4e in4estors a repayment of the debt principle on time% In4estor can use this information in se4eral ways as to refuse to buy the security with a credit rating below in4estment grade, or below a specific in4estment grade% Furthermore, such ranking pro4ides an indication of the in4estment premium that would be re@uired for a particular le4el of risk, assuming in efficient markets, the higher the risk is, the higher and the reward will be andJor sell securities from their in4estment portfolios whose credit rating is downgrades below certain le4el =&oyle =1551?: ,39?% (dditionally, a credit ranking system is seen as a robust analytical framework, which pro4ides an eCcellent tool for monitoring the e4olution of credit risk o4er time% Moreo4er, institutions need to assess the reco4ery prospects for distressed debt, in particular during recession, when a part of their portfolio is impaired% +eferring to the introduction of this chapter, 68ould you lend your money to this:= =Kanguin =1552?: ,:? gi4en the described assessments, loan pro4iders would ha4e to some eCtent guaranteed their worries i%e% if there is sufficient likelihood of the borrowed money to be paid back on time, presented in this old>@uestion% 6et, drawing on these inputs, IS =1559? emphasise that credit rating information should support, not replace, in4estor due diligence = IS =155<?: ,?% The greatest rating agencies mentioned abo4e, apply separate categories for each short term debt,0, which is illustrated in Table ,,8 that eCpress their assessment of the outlook for compliance with the payment obligation%
15

Ahile, similar symbols are used for long term rating systems of the rating agencies, howe4er, this will not be illustrated here as it is out of the scope of this paper =(nson et al% =1552?: 10?% 16 See (ppendiC 1, for the ratings%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

3actors 'onsidered in .ating There are 4arious factors rating agencies considered when representing their ratings% (nson et al% =1552? describes these as the four &s of credit i%e% character, capacity, collateral and co4enants% The first & includes the foundation of sound credit i%e% the ethnical reputation as well as the business @ualifications and operating record of the board of directors, management, and eCecuti4e responsible for the use of the borrowed funds and repayment of those funds% For instance, MoodyOs try to understand the business strategies and policies formulated by the management% They further analyse the strategic direction, financial philosophy, conser4atism, track record, succession planning, and control systems etc% The second & considered in rating is the capacity or the ability of an issuer to repay its obligations, whereas the neCt factor considered is collateral, where it is assessed whether the assets guarantee to the debt and the debt holder% 'ere MoodyBs, analyses the financial statement of the specific firm ,:% The last factor considered is the co4enant condition of the lending agreement% &o4enants mirror restrictions on how management functions the company and conducts it financial affairs% ( default or 4iolation of any co4enant may carry great weight as an early warning enabling in4estors to take actions before the situation deteriorates further% Therefore, co4enants play a significant role in minimiFing risk to creditors as it assist pre4ent unconscionable transfer of wealth from debt to e@uity holders =(nson et al% =1552?: 10>1:?L Michel =155,?: 181>83?% ( 4ery crucial element to emphasise is that in the international money market, credit risk is not the only risk faced by participants but currency risk also plays a 4ital role due to the in4ol4ement of foreign eCchange rates etc% =Krabbe =,998?: 11:?% (ccording to factors considered in rating, it is noticeable that currency risk has been ignored in credit rating analysis =SF+& =155:?: 2?% Furthermore, in general, swap arrangements also in4ol4e credit risk i%e% the credit risk to a dealer is the possibility the counterparty of the dealer may default when the 4alue of the swap to the dealer is positi4e =Krabbe =,998?: 33,?% Thus, the following sub>chapter aims to describe the effect of the turmoil to the foreign eCchange swap markets from a theoretical framework%

17

.ther factors eCamined by MoodyBs are for instance, industry trends =here it is eCamined the 4ulnerability of the company to economic cycles, the barriers to entry, and the eCposure of the company to technological changes?, regulatory en4ironment, basic operating and competiti4e position, financial position and sources of li@uidity, company structure, parent company support agreements, and special e4ent risk =(nson et al% =1552?: 1:?%

Side '& af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management $:':$ 7i;uidit 0isk ( well functioning money market is 4ery important, in order to ensure that financial market participants can adHust their li@uidity positions and to pro4ide funds for growth = IS =155:t?: ,?L ;an Kreuning =1553?: ,8:?% $i@uidity risk is defined as the risk of insufficient li@uidity funds on hand to meet obligations i%e% the ability of the bank to meet its liabilities when they fall due ='effernan =1550?:,50?L ;an Kreuning =1553?: ,8<?L 'orcher =1550?: 22?L .*&D =155:?: 229?% This is a @uite important element in the interbank market trading with short term instruments where day to day operations is re@uired to sustain the acti4ity in international interbank markets% In day to day operations, the management of li@uidity is usually achie4ed through the management of the assets of the bank% Ahile in the medium term, li@uidity is also addressed through management of the structure of the liabilities of the bank ,< =;an Kreuning =1553?: ,8<?L .*&D =155:?: 229?L IS =1559abc?: 123?% In the literature it is distinguished between two types of li@uidity risk i%e% funding risk and market li%uidity risk =)lesner =155<?: 2?% 3unding risk is defined as risk of insufficient or =prompt? li@uidity funding of the bank to meet its liabilities% Funding risk is further composed into refinancing, time and call risk% +efinancing risk is defined as the possibility that a bank will not be able to refinance eCisting maturing deposits, liabilities etc% while, time risk is the negati4e li@uidity effect of defaulting payments from the asset site e%g% due to defaults in lending portfolio and call risk, is the risk due to difficult predicting of liabilities related to deri4ati4es, li@uidity facilities, and other off balance sheet acti4ities% -arket li%uidity risk is the inability of a bankJfirm to realiFe assets without a siFeable loss due to lacking market depth,9 = IS =,999?: 0?L runnermeier 7 )edersen =155<?: ,>1?L )lesner =155<?: 0?L oF=155<?: I?% It is noteworthy to stress that both funding and li@uidity risk are nearly related as a bankJfirm may be obligated to realiFe assets on a bad time, in order to obtain funds to redeem obligations% )lesner =155<? stresses that, at worst a negative feedback loo" can occur between these types of risk% I%e% an initial decrease on the price of the asset can lead to margin calls 15, which can only be met trough rummage sale of assets, which not surprisingly fall further in prices, which
18

$i@uidity risks are, in general, managed by the asset>liability management committee =($&.? of the financial institution, which re@uires an understanding of li@uidity and other market, and credit risk eCposures on the balance sheet =Kreuning =1553?: ,8<>,89?% 19 /sually, market li@uidity is considered according to at least one of three possible dimensions: tightness, depth and resiliency% Tightness is how far transaction prices di4erge from mid>market prices, and can generally be measured by the bid>ask spread% 2e"th indicates either the 4olume of trades possible without affecting pre4ailing market prices, or the amount of orders on the order>books of market>makers at a certain time% .esiliency refers to the speed with which price fluctuations resulting from trades are dissipated, or the speed with which imbalances in order flows are adHusted = IS =,999?: 0?% 'ence, this will not further be elaborated on, as this part aims to gi4e a brief description of the market li@uidity risk, in order to enable eCplaining the effect on the international money market% 20 ( demand for additional funds because of ad4erse price mo4ement%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management restarts the margin call again% Kenerally, all types of institutions are eCposed to li@uidity risk, hence in particular interbank markets, which ha4e an intermediary role, and thus eCposed to a higher eCtend% (s the broader financial systems along with the economy of the world are strongly dependent on the core money markets meet their function as supplier of li@uidity =)lesner =155<?: 0?L oF =155<?: 11?% It is not a secret that the effect of the turmoil in the international interbank market has been the main reason for the scale of the financial turmoil as it is the heart of the whole financial system% Therefore, a sound stability in the international money market is a crucial subHect% 3actors 1i%uidity .isk 2e"ends 0n The li@uidity and li@uidity risk of a bank depends generally on internal as well as eCternal factors i%e% the balance sheet structure, financial soundness, market access of the bank, and market de4elopment% The balance sheet structure1, of a bank is an outcome of se@uence of business decisions, where the goal is to maintain the highest possible marginal rate% &on4entionally, core deposits are percei4ed as the most stable funding source% &ore deposits include ordinary demand deposits and other types of deposits% (lmost all these types of deposits are guaranteed by some sort of deposit guarantee scheme and an implicit li@uidity guarantee from the 6lender of last resort=% Due to demand of money, there will be daily in>and>out transactions of these deposit, howe4er, as long as there is a trust to the bank and the banking system is steady, the bank will ha4e an a4erage deposit le4el as a permanent and cheap funding source% The financial soundness of a bank is the ability of making a profit, which is 4ital for the possibilities of obtaining funding through more 4olatile funding sources such as interbank markets% In this market, the lender is not protected by =eCplicit? guarantees, and therefore it would demand a compensation for the risk in4ol4ed through credit spreads% ( degradation of the soundness of the bank or a general decrease of creditors risk tolerance would immediately be mirrored in the spreads and thereby make it more eCpensi4e to or in the worst case, make it impossible to borrow% The market access of the bank is 4ital to obtain funds through capital markets, e%g% issuing bonds, or asset backed securities =)lesner =155<?: 0>8?% 'ence, a 4ery essential subHect to call attention to is that li@uidity risk is interrelated with the credit risk, as gi4en a high credit risk may imply and thereby result insufficient funds to meet day to day operations, as a result of decline in confidence among in4estors% IS =155:t? also underscore that a
21

See (ppendiC 3, for alance Sheet Structure 7 $i@uidity +isk for banks

Side $' af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management loss of li@uidity in a money market generally has more serious effects than a loss of li@uidity in markets for longer term instruments, due to the large amount of money market instruments become due each day% Furthermore, de4elopments in the global financial markets ha4e highlighted that gi4en pressure on li@uidity and balance sheets, combined with heightened credit concerns, made banks reluctant to pro4ide others with term funding11 i%e% interbank market loans with terms longer than o4ernight = IS =155:t?: 1?%

Part %%& 6? much less well documented as"ect of the turmoil is how the turbulence in money markets =in particular interbank markets? s"illed over to foreign exchange &34) swa" markets= = IS =155<?: 3?% Therefore, this part will co4er the theoretical framework of this spill o4er 4ia the co4ered interest parity and its relation to the FX swap market, the de4iation of the &I)% 2.2 Co$ere %nterest Parity

The traditional theory of forward eCchange was set forth by "eynes in his Tract on -onetary .eform, which mainly concerned about the possibility of interest arbitrage% Thus, this was further elaborated on the forward eCchange market by Sohmen =,98,, ,988? and Tsiang =,909?% Therefore, the following theoretical presentation initially describes the co4ered interest arbitrage presented by Sohmen =,98,, ,988? and Tsiang =,909?, followed by the co4ered interest parity condition and its relation to the FX swap market% $:$:' )overed Interest Arbitra!e *4en in the ,<55s there was e4idence of foreign eCchange traders engaged in co4ered interest rate arbitrage =)eel and Taylor =1551?: 01>03?% (ccording to anecdotal e4idence suggested by to $otF =,<<9?, +affalo4ich =,<90?, SchulFe>Kae4ernitF =,<99?, 'aupt =,<91?, Margraff =,952? co4ered interest rate arbitrage was indeed common in both in *urope and in the /nited States, but the acti4ity in forward eCchange operations, in general become much more intense in the interwar floating rate period ="eynes =,913?: ,51? L *inFig =,93:?, =,981?: ,:,, 130?L )eel 7 Taylor =1551?: 01>03?% Tsiang =,909? emphasises that short>term funds tend to flow from one centre to another e%g% from dollar money market to pounds sterling money market, if the rate of return in one money market is
11

The bankruptcy of $ehmanBs, mid>September 155<, caused a complete collapse of confidence in the financial health of money market counterparties% This resulted in banks hoarding li@uidity, interbank rates climbed to historical highs =155<d?: 9>,,?% 'ence, this will further elaborated on chapter 0%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management higher than that in the other, after the risk of eCchange fluctuation is eliminated by a forward eCchange transaction in the opposite direction =Tsiang =,909?: :<>:9?% In other words, if the interest rates are higher in the domestic country than in the foreign country, then the currency of the foreign country would be selling at a premium in the forward market, while if interest rates are lower in the domestic country, then the foreign currency would be selling at a discount in the forward market 13 =Krabe =,998?: ,58?% The notation for the formulation abo4e is as the followingL Ahere St represents the domestic currency price of foreign currency in the spot market at time t, F t is the price of foreign currency deli4erable forward at time t, id t it is the domestic interest rate at time t and in if t is the corresponding interest rate abroad at time t% The proposition states that short>term funds would tend to flow from dollar money market to pounds sterling money market if money market, if Ft J St =,P if t? Q =,P id t? Ft J St =,P if t? R =,P id t? =,? =1? .n the other hand, funds would tend to be transferred from pounds sterling money market to dollar Ki4en N,55 in4ested for three months in /S money market would be N,55 S=,P id t?, and if the same amount in dollars is con4erted into sterling at the current spot rate and in4ested for three months in /" money market and then con4erted back into dollars at the current forward rate for sterling for three months deli4ery, it would become If ,55N C Ft J St =,P if t?% If ,55N C Ft J St =,P if t? Q N,55 S=,P id t?, arbitragers would gain a net profit by a temporary transfer of funds from dollar money market to pounds sterling money market, whereas if ,55N C Ft J St =,P ift? R N,55 S=,P idt?, the net profit would be gained by a transfer of funds from pounds sterling money market to dollar money market% Figure 2%, describes the steps that an arbitrager would implement to perform a &I( transaction% Figure 2%, 12, illustrates the conditions where ,55N C Ft J St =,P if t? Q N,55 S=,P id t? and for the other condition where ,55N C Ft J St =,P if t? R N,55 S=,P id t? it would ha4e been the other way around i%e% transfer of funds from pounds sterling to dollar money market instead of from dollar to pounds sterling money market%

23

*%g% if interest rates are higher in /S than in /", then the forward pounds sterling would cost more /S dollars than will the spot pounds sterling% The forward pounds sterling will be at a premium and the forward dollar at a discount% If interest rates are higher in the /" than in the /S, then the forward sterling pound would cost fewer dollars than will the spot sterling pound% The forward sterling pound will be at a discount and the forward dollar at a premium =Krabe =,998?: ,58?% 24 See (ppendiC 2

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Tsiang =,909? emphasise that it has been argued that, gi4en arbitrage funds do not run out, such arbitrage operations10 would tend to eliminate this ine@uality through some or all of the following possible effects: raising the spot rate of sterling in terms of dollars =S+?, lowering the forward rate =F+?, raising the short term interest rate in the /S =id t? and lowering the one in /" =if t?% (s a conse@uence, the e@uilibrium relationship between the spot and forward eCchange rates in one side and the interest rates in the two financial centres on the other side is said to beL F+JS+ =,P if t? T =,P id t? =3? In other words, the process of co4ered interest arbitrage dri4es the international currency and money markets toward the e@uilibrium described by the co4ered interest rate parity% Thus, co4ered interest arbitrage should continue until interest rate parity is re>established, due to the fact that arbitragers are able to earn risk free profits by repeating the cycle as often as possible =Da4id et al% =,99<?: ,12?% $:$:$ )overed Interest *arit <)I*= &o4ered interest parity =&I)? was not recorded as a formal condition in the finance literature until the twentieth century, although foreign eCchange traders were engaged in co4ered interest rate arbitrage as mentioned abo4e =)eel and Taylor =1551?: 01>03?% 6et, "eynes =,913? ga4e the initial 4erbal formal definition of co4ered interest parity =&I)? 18, 6 forward %uotations for the "urchase of the currency of the dearer money market tend to be chea"er than s"ot %uotations by a "ercentage "er month e%ual to the excess of the interest which can be earned in a month in the dearer market over what can be earned in the chea"er= ="eynes =,913?: ,53>,52?% (s presented abo4e, Tsiang =,909? states the e@uilibrium relationship between the spot and forward eCchange rates and the interest rates in two money markets as the following =Ft J St?S =,P if t? T =,P id t? =3? Tsiang =,909? further, states that gi4en Ft J St eCpressed as , Pp, where p =i%e%, =F t > St?J St? is the forward premium =or forward discount, if negati4e? on sterling as defined abo4e, then e@uation =3? abo4e becomes this e@uation can be further simplified to =,Pp? =,P if t? T =,P id t? pT id> if =2? =2B? If the term pib in =2? is considered as of second order of small magnitude and therefore neglected, This corresponds to the usual 4erbal formulation of the so>called interest parity theory of forward eCchange, which maintains that the forward premium =or discount? tends to be e@ual to the interest
25 26

I%e% for instance, transfers of spot funds from /S to /" along with an e@ual amount of forward sales of sterling for dollars% in an article first published in a ritish newspaper, The -anchester 7uardian in ,911 and subse@uently published in the re4ised form in his Tract on Monetary +eform =)eel and Taylor =1551?: 03?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management differential between the two money markets concerned =Tsiang =,909?: <5?% Moosa =1553? highlights that this relationship is an application of the law of one price to financial markets i%e% identical financial assets should produce identical returns after co4ering the foreign eCchange risk =Moosa =1553?: ,9>15?% The abo4e statement has been reformulated by Da4id et al% =,99<? as the followingL 6the difference in the national interest rate rates for securities of similar risk and maturity should be e%ual to, but o""osite in sign to, the forward rate discount or "remium for the foreign currency, exce"t for transaction costs= =Da4id et al% =,99<?: ,11?% Figure 2%11: depicts the interest rate parity condition, in order to gi4e a better understanding of the condition% (ssume that St represents the spot eCchange rate i%e% the pounds sterling>dollar rate, @uoted in terms of dollars per unit of pounds sterling, Ft is the three>month forward pounds sterling> dollar rate @uoted as for the spot rate, id t is the short>term dollar interest rate per three months, and if
t

is short>term pounds sterling interest rate per three months% (gain, gi4en an in4estor with N,55

who in4ests in a dollar money market instrument e%g% three months, the in4estor would earn the dollar rate of interest, where id is the dollar rate of interest% This would result in a gain of =,P id t? at the end of the period and thus, the three month in4estment in the dollar money market would become N,55 S=,P id t?% 'ence, gi4en that the same sum in dollars is con4erted into pounds sterling at the current spot rate and in4ested for three months in the pounds sterling money market instrument and then con4erted back into dollars at the current forward rate for pounds sterling for three months deli4ery it would become ,55N C Ft J St =,P if t?% ( dollar based in4estor would e4aluate the relati4e returns of starting in the top left corner of figure 2%,, and in4esting in the dollars compared to in4esting in the pounds sterling market i%e% going around the boC to the top right corner% The comparison of returns would be =,P id t? T StS=,P if t? S =,J Ft?% The left hand side of the e@uation is the gross return that the in4estor would earn by in4esting in dollars% The right hand side is the gross return that the in4estor would earn by eCchanging dollars for sterling at the spot rate, in4esting the pounds sterling proceeds in the sterling money market, and simultaneously selling the principal plus interest in pounds sterling forward for dollars the current 95>day forward rate% Ignoring transactions costs, if the returns in dollars are e@ual between the two alternati4e money markets in4estments, the spot and forward rates are considered to be at interest rate parity =I+)?% The transaction is co4ered due to the fact that the eCchange rate back to dollars is guaranteed at the end of the 95 day period =Da4id et al% =,99<?: ,13?% Se4eral authors such as Tsiang =,909?, Spraos =,909?, and =Frenkel 7 $e4ich =,9:0? ha4e
27

See (ppendiC 2

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management emphasiFed the shortcoming of the interest rate parity theorem, hence this will be further elaborated on in chapter 0% $:$:( +;uilibrium between Interest 0ates and +>chan!e 0ates Figure 1%, depicts the no arbitrage condition i%e% e@uation =3?% The interest rate difference is measured on the 4ertical aCis, which illustrates the percentage difference between foreign =pounds sterling denominated? and domestic =dollar>denominated? interest rates, and the horiFontal aCis depicts the forward premium or discount on the pounds sterling% The interest rate parity line illustrates the e@uilibrium state, hence transaction costs grounds the line to be a band rather than a thin line% In general, transaction costs arise from foreign eCchange and in4estment brokerage costs on shorting and going long securities =Da4id et al% =,99<?: ,12?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
3igure 2 + !nterest .ate (arity D E%uilibrium

E difference between if V id

2 1 5 X >2 > 8 > < >8 >2 >1 5 1 2 6 ! 2,< 3 E premium on foreign currency =U? /

$ource< &2avid et al &+99>)< +2C) -ote: The gi4en, percentage difference between if>id and the percentage premium on foreign currency =U? are ficti4e numbers, in order to gi4e a more clear understanding this chapter%

)oint C corresponds to one possible e@uilibrium position, where a >2 E interest differential on sterling securities would be offset by a 2 E premium on the forward sterling% The point abo4e the line i%e% the dise@uilibrium point /, would encourage the interest rate arbitrager% That is the situation presented in figure 1%,1<% )oint / is located abo4e the interest rate parity line due to the fact that the percentage differential in interest rate is >2 E =annual basis?, while the premium 19 on the forward sterling is 2%<3E =annual basis?% 'owe4er, the situation illustrated by point / is unbalanced as all in4estors would ha4e an incenti4e to eCecute the similar co4ered interest arbitrage% The net result of the dise@uilibrium is that fund flows will narrow the gap in interest rates andJor decrease the premium on the forward sterling% That is market pressures will result point / to shift toward the interest rate parity band% Thus, e@uilibrium could be obtained at point 6, or at any other position between X and !, depending on whether forward marker premiums are more or less easily shifted than interest rate differentials =Da4id et al =,99<?: ,18>1:?% Da4id et al% =,99<? stress that the arbitrages gain is nearly risk free, eCcept for a bank failure% It is also emphasised that some authors suggested the eCistence of political risk as some go4ernments
28

SubHect to the assumption that the ,PidT ,%52 and ,Pif T ,%51 for 95 days%

19

/sing the forward premium calculation, the actual premium on the sterling can be calculated as the followingL =S ,> S1?J S1 S,55S=385 daysJ95 days? TiN>iU =Da4id et al% =,99<?: ,12?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management may apply capital controls that would pre4ent eCecution of forward contracts% 'ence, this risk is fairly distant for co4ered interest arbitrage between maHor financial centres, as a great deal of the funds used for co4ered interest arbitrage is in *urodollars, howe4er, this could be a concern for countries with political and fiscal instabilities Da4id et al% =,99<?: ,18?% = IS =155<? also emphasise that in todayBs K,5 currency markets, political risk is insignificant% It is further underscored that for &I) to hold it depends on lack of credit default risk = IS =155<?: 0?% i%e% to say, in the interest rate parity theorem, credit risk has not been considered, as in credit risk theory, currency risk has not been considered% -e4ertheless, the importance of credit risk is of maHor conse@uence in the recent financial turmoil% 6et, chapter 0 will further goes in deep with these possible factors that would ha4e an effect on the de4iation of the &I)% $:$:. The FX Swap & )overed Interest *arit <)I*= The neCt important @uestion rises as an attempt to understand the relation between the money market spill o4er and the FX swap markets, what is the relation between the FX swap and the &I)% Thus, the first part will describe what a FX swap is and thereby its relation to &I)% (n FX swap is described as a contract in which one party borrows a currency from another party, and at the same time lends a second currency to another party% FX swaps are percei4ed as effecti4ely collateralised transactions, IS =155<? stress that the collateral does not co4er the entire counterparty risk as if one party to the swap defaults during the life of the contract period, the counterparty needs to reconstruct the position at the current market price, which re@uires replacement costs = IS =155<?: 2?% Duffie 7 'uang =,998? further support that FX swaps are eCposed to greater counterparty risk than interest rate swaps for the reason that, dissimilar to interest rate swaps, FX swaps entail the eCchange of notional amounts at the start of the contract% Moreo4er, the 4olatility of FX rates tend to be greater than that of interest rates, which means that this also contribute to promote the counterparty risk in FX swaps abo4e that of interest rate swaps =Duffie 7 'uang =,998?: 939?% (n financial institution which is in call for foreign currency funding ha4e the option to either borrow directly in the uncollateralised spot market of the currency or borrow in another, in general the domestic, uncollateralised spot market of the currency and con4ert the proceeds into an obligation in the desired currency through an FX swap% IS =155<? identify this second option of Ki4en a financial funding as the total funding cost, which is called FX swap implied rate%

institution raising dollars 4ia an FX swap with euros, it eCchanges euros for dollars at the FX spot rate while contracting to eCchange in the re4erse direction at maturity at the FX forward rate% The FX swap implied dollar rate, in gross terms, generated from the euro can be written asL
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Ft,tPs J StT =,Pift,tPs? Ahere St is the FX spot rate between the sterling and dollar at time t, Ft,tPs is the FX forward rate contracted at time t for eCchange at time tPs, and it,tPsf T it,tPssterling is the uncollateralised euro cash fiCed interest rate from time t to time tPs% Ft,tPs J St corresponds to the sterlingJdollar forward discount rate that is used for the FX swap price @uotation35% The relati4e cost factor plays a significant role in the use of the FX swap to raise dollars i%e% whether an institution would be encouraged to borrow domestic currency funds in the uncollateralised spot market and use the FX swap to raise dollars, should depend on whether the FX swap implied dollar rate is lower than the rate of the uncollateralised dollar funds% In other words, the choice between in4esting in collateralised =FX swap? 4ersus uncollateralised dollar funding, dependence on the perspecti4e of co4ered interest parity as it implies a comparison of one uncollateralised rate e%g% dollar, 4ersus an uncollateralised rate e%g% sterling combined with an FX swap =sterling for dollar?% The e@uality of dollar rates and of FX swap implied dollar rates defines a the following conditionL ,Pit,tPs d T Ft,tPs J St =,P rt,tPsf? =a? Ahere it,tPsd is defined as the uncollateralised dollar cash fiCed interest rate% *@uation =a? corresponds to the co4ered interest parity condition as presented abo4e in section 2 2 2% (s mentioned abo4e, &I) states that interest rate disparities between currencies should be perfectly reflected in the FX forward discount rates for the reason that, otherwise arbitrageurs could transact in interest and eCchange markets to make a risk free profit% ( fair amount of research has been de4oted to the empirical 4alidation of the condition and 4arious empirically studies ha4e shown that the parity condition is not always satisfied% The reasons for the de4iation of the &I) will be further elaborated on the chapter 0%

30

More, correctly the price of FX swap is usually @uoted as Ft,tPs > St% +eferring back to the interest rate parity i%e% e@uation =3?, the forward rate is gi4en as a function of the spot rateL Ft,tPs T St ==,Pid? J=,Pif? ?, therefore the spot rate should be the swap rate Ft,tPs > St = Krabbe =,998?: ,59?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

)/A*T+0 (: B0I+F S#MMA0? 1F +@+,TS 7+A-I,A T1 T/+ )0ISIS I, T/+ I,T+0BA,9 A,- FX S8A* MA09+T &redit> li@uidity crises are not a new phenomenon, the first credit crunch was obser4ed in ,988, which was due to the municipal bond market =Aray =,999?: 3?% This period was followed by maHor disruptions in financial markets, the (sian currency crisis in ,99:, and the +ussian 3, and the $T&M31 crisesB in ,99<% (lthough, the crises ha4e occurred based on 4arious reasons such as credit loss, increasing interest rates, what are characteristics for all of them is that li@uidity issues ha4e appeared in financial markets subse@uentially =)lesner =155<?: 2?L =Danmarks -ationalbank =,999?: 0,>03?% The main source of uncertainty surrounding the economic outlook of today has been due to the deterioration of the /S housing market = o* =155:?: ,:?L = oF =155<?: 15?L )lesner =155:?: 1?L runnermeier =1559?: <1?L "empa =155<?: 0?L Danmarks -ationalbank =155<f?: 3:?% 6et, in order to understand the financial crisis, which surfaced in the summer of 155: and hit the core money markets, it is 4ital to recall some key factors leading up this turmoil% *ey 3actors 1eading u" the Turmoil in the !nternational -oney -arkets In the period of 1551>52, there had been recorded an unusual stability and historically low interest rates in the financial markets of de4eloped countries 33 ="empa =155<?: 3?L = runnermeier =1559?: ::?% (ccording to "empa =155<? this has pursued in4estors, facing historically low interest rates, higher yields and turned to more risky assets and hea4y le4eraging% Increased market li@uidity, hence, led to an unsafe reaction i%e% once a certain market section was targeted, increasing li@uidity reduced the 4olatility and resulting yields which persuaded in4estors to mo4e to e4en more risky assets ="empa =155<?: 3?% (t the same time, the banking system underwent a 4ital transformation i%e% the traditional banking model, in which the issuing banks hold loans until they are repaid, was replaced by the Moriginate to distribute# banking model% The initiati4e behind the Moriginate and distribute# scheme 32 was to securitiFe and sell the loans on the financial markets =*& 155:?: ,1?% In the traditional banking, the credit granting and credit risk relied in the bank, and therefore, a proper credit rating was conducted to eligible customers% Ahereas the new scheme allowed the banks that originally granted
3, 31

In (ugust ,99<, +ussia suspended payments on its foreign debt and abandoned stabilisation of the rouble against the dollar =Danmarks -ationalbank =,999?: 0,?% See (ppendiC 0 See (ppendiC 0 34 See (ppendiC 0 for the maHor actors in the new model
33

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management the loans to transfer part of the risk to counterparties and obtain the li@uidity for new lending 30% This meant that as the banks had little incenti4e to take care of appro4ing loan applications and monitoring loans as they only faced the 6"i"eline risk= of holding a loan for few months until the risks were passed on =)lesner =155:?: 3?L "empa =155<?: 3?L = runnemeier =1559?: <1?L Danmarks -ationalbank =155<f?: ,1?% )lesner =155:? stresses that the scheme also in4ites to moral haFard as the intermediary bank =or broker? focus on deal flow, and in seeking commission ha4e led to warped creditworthiness e4aluations% This has been the case, in particular with house buyers 38, who in traditional banking would face difficulties obtaining a loan, ha4e managed to obtain loans with the new scheme% These types of loans ha4e been forwarded by the intermediary brokers to in4estment banks, and as a mean to offload risk, banks typically created structured products often referred to as collateralised debt obligations =&D.s?, which offloaded the risk to institutional in4estors, hedge funds, and other participants on the global financial markets = runnemeier =1559?: :<>:9?L )lesner =155:?: 2?3:% 'ence, the o4erloaded li@uidity pumped into the markets during this time period started to back fire, in particular in mid>1552 where an increase in the Fed Funds +ate 3< started% (s an outcome this affected many sub>prime borrowers as they were unable to repay their loans% (lthough, the (merican &entral ank tried to inter4ene through the 1550 and the first half of 1558, the turmoil was already out of control =)lesner =155:?: 3?% -e4ertheless, it is to be noticed that according to )lesner =155:? the compleC instruments such as &D.Bs are not the factor to hold responsible as it is solely a redistribution of the credit risk at better but rather the moral haFard issue in the model that is the main subHect% (dditionally, the fact that new participants engaged into in4esting in compleC and illi@uid products, in the credit market when lacking knowledge and eCperience with pricing and managing credit risk, deteriorate the circumstances further =)lesner =155:?: 0?% Furthermore, eCcess li@uidity in the markets has been presented as a significant reason to the de4eloped distress in the /S housing market, and the lack of early inter4ention of central bank of /S =)lesner =155:?: 3?%

35

This is obtained by separating assets from the balance sheet, and makes the in4estor directly dependent of the outcome of this% Ahen the assets are sold forward to the S);, and the banks do not ha4e any Huristic obligations towards the assets, the credit risk will be gradually decreased =Krosen =155<?: ,>3?L )lesner =155:?: 2>0?% 36 (lso called subprime borrowers, as e4en -I-G( =-o Income, -o Gob, (ssets?, and $iar $oans ha4e been issued loans =)lesner =155:?: 2?%
3:

'owe4er, con4entionally in4estment banks do not perform credit analysis, and for that reason they were left with the ratings of the bonds =&D.> tranches? credit @uality, performed by the credit agencies% (s the credit rating agencies were paid by the in4estment banks, subHecti4e opinions about the creditworthiness of the issuer ha4e been performed =)lesner =155:?: 2?L runnermeier =1559?: <1?% ( remarkable issue related to ratings on compleC instruments such as &D.Bs, is that they are not comparable to con4entionally bonds due to the high credit risk related to &D.Os =)lesner =1550>1?: ,2>,0?% 38 See (ppendiC 0, for the de4elopment of the Fed Funds +ate from ,99,>155:%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management .4erall, a combination of cheap credit and low lending standards resulted in the housing rage that laid initially basis for the credit crunch followed by the li@uidity crisis =)lesner =155:?: 3?L runnemeier =1559?: :<, <1?L erman =155:?: &,?L o* =155:?: ,:?% (s pointed out by +icardo G% &aballero and (r4ind "rishnamurthy in the ank of France Financial Stability +e4iew = oF =155<? and )lesner =155:?, defaults on subprime mortgages were eCpected as the subprime market is the most risky segment of the mortgage market% It is hardly surprising that some borrowers would default on their loans% 6et, the occurrences of defaults ha4e been the trigger for the current se4ere li@uidity crisis that has rapt markets from consumer credit to corporate credit = oF =155<?: ,5?L )lesner =155:?: ,?% The acknowledged sub>prime related cost in the financial sector has been stated to be ,15 billions dollars =Danmarks -ationalbank =155<>,?: 1?% oF =155<? further highlights that the subprime losses were relati4e small, e4en the worst case estimates ga4e a loss at /SD 105 billion, which is 6a dro" in the bucket relative to the trillions of dollars of financial instruments traded in the world5s market"laces= = oF =155<?: ,5?% F$ $ub-(rime 'risis Trigger 8ider -arket Turmoil D 9it 'ore -oney -arkets ( fundamental @uestion is how did the /S sub>prime crisis to such an enormous eCtent that the core money markets ha4e been hitI Figure 3%, below describes the o4erall de4elopment @uite well in a sub>se@uential manner = o* =155:?: 25?%
3igure , 2 The "hases of the 'risis

$ource< &#oE &2007)< G0)

(s mentioned abo4e, initially, it was obser4ed a rise in the /S sub>prime mortgage arrears% This resulted in many homeowners into force sales of their properties% Followed by this, the crisis
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management spreads to other markets through the &D.Bs and other compleC products 39% (s the cost of insuring a basket of mortgages of certain ratings against default increased downgrading on related ( S and other structured instruments occurred% This resulted in a series of write>downs and loss of confidence in the 4alue of ( S globally% (s a part of the Moriginate and distribute# model, many banks created separate entities, SI;s, which were dependent on the originate banks but not included in their balance sheets25% SI;s were established to fund the &D.s through ( &)s% The maHor obstacle relied in the fact that ( &)Bs are typically short term in4estments that mature between 3>8 months, were issued subse@uently with the security of payments from &D.Bs =*& =155:?: 31?% This of course resulted in a duration gap% Thus, as the li@uidity in the securitiFation market dried up, outstanding ( &) could not be rolled o4er, and SI;s had to sell assets in order to obtain li@uidity, as many of the eCposures were effecti4ely financed on a rolling basis by short term funds = IS =1559>,5,th?: ,:?% The already ongoing sale of special li@uid &D.s resulted in rapid decrease in market prices of high V@uality tranches2,% The degraded market li@uidity resulted in li@uidity inHections from the li@uidity facilities of the originated banks, which meant an increase of call risk as the risk flow returned to the balance sheets of the banks% (long with shortage of li@uidity, maHor banks wrote>down mortgage related securities e4en further% (lthough the aggregate amount of write downs21 was higher in the united state, the amount of write downs of *uropean banks is remarkable% The e4ents in the /S impacted financial intermediaries in *urope as credit risk from /S ended up in the hands of global in4estors =*& =155<>I?: ,5?L *& =155:?: 3,>31?% (s figure 3%1 depicts in Guly 155: the market for short term ( &) started to dry up = runnermeier =1559?: <2?%

39 40

These products will not be elaborated on here, as it is out of the scope of the paper% This was due to the asel regulations, howe4er this will not be further elaborated on as it is out the scope of this paper% 41 This triggered further market turmoil in#safe ha4ens#, go4ernment bond markets =)lesner =155<?: :?%
21

See (ppendiC 8, for the /S *uropean and *uro (rea anksB Arite>Downs in the period from December 155: to .ctober 155< 7 Arite>Downs from Structured Finance )roducts, broken down by region and sector of May 155<%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
3igure , , 0utstanding ?#'(43 and Fnsecured '(

$ource< &#runnermeier &2009)<>G)

(ll this resulted in dramatic li@uidity degradation due to the sharp decline in the risk appetite of global in4estors and increase in market 4olatility, which hit core money market markets on 9 (ugust 155: =)lesner =155<?: :><?L )lesner =155:?: 3, 0?L = o* =155:?: ,:>,9, 25?L = oF =155<?: ,5?L *& =155:?: <,?L IS>-o%3, =155<?: ,?L IS =1559>,5,th?: ,:?% It is also to be stated that the &) issuing 4ehicles return to their sponsor banks and their li@uidity pro4ision commitments, prompted banks to retain contingent li@uidity, which in turn brought the interbank market to a standstill% *& =155:? further argues that the interbank market acti4ity may ha4e been affected further by uncertainty about the @uality of the assets counterparties =*& =155:?: 35>3,?% Thus, the rest of the paper aims to gi4e a more accurate picture of the de4elopment of the crisis in the money markets and the spill o4er to the FX Swap market%

43

See appendiC ,1, for the structure of ( &) )rogram%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

)/A*T+0 .:

-+S)0I*TI@+ STATISTI)S

This section aims to describe the financial situation in the international interbank markets and the FX swap markets by the use of a4ailable statistics% This chapter is di4ided into two main parts, the first part describes the international interbank market, and thereafter describe the tension de4eloped in the international interbank markets through two measures that reflect the li@uidity risk and the credit risk% The second part of the paper international FX swap markets followed by a description of the market 4ia e@ui4alent measures% 4.1 %nternational %nterban( Mar(ets

This sub>section, primarily aims to pro4ide an o4er4iew of the fundamental characteristics of the International Interbank Markets% Initially, a brief historic introduction to the international interbank markets will be presented, which will be followed by a description of what he interbank market is, and how it is functioned is described% Thereafter, there will be a brief introduction of the role of money market rates% .:':' Brie" /istoric Introduction o" the International Interbank Market 63inancial markets have existed for several years i e since mankind settled down to growing cro"s and trading tem with others 3inancial markets are in different forms and o"erate in varied ways, which serve the same functions such as "rice settings, asset valuation, arbitrage, raising ca"ital, commercial transactions, investing, and risk management= =$e4inson =1550?: ,>1?% *4en though that there eCists e4idence that foreign currency deposits were held by banks before Aorld Aar II, it is only since the late ,905s that the interbank markets ha4e grown rapidly and consistently22 =(r4ind =,992?: ,12?% The growth in the international trade increased the demand for international currencies and the interbank market was created as a result of legal transactions of pri4ate in4estors looking for the best returns on their in4estments =(r4ind =,992?: ,10, ,1:?% 'ence, the interbank market eCpanded significantly in recent years as a result of the general outflow of money from the banking industry20 =$e4inson =1550?: 3:?% Today, the interbank market is an

44

Dufey and Kiddy identified three necessary conditions for the functioning of eCternal markets, which were not, satisfied until the late ,905s and thereby the reason for why the interbank market did not start growing until the late ,905s % ,?Foreign>based entities must possess the freedom to maintain and transfer demand deposit balances i%e% no restrictions on nonresident inpayments, outpayments, and transfers, 1? Interbanks must be able to offer eCternal deposits and loans at competiti4e rates in a con4enient location, 3? Demand for eCternal currency deposits and loans =Dufey and Kiddy =,992?: ,5>,,?% 45 This process is referred to as disintermediation =$e4inson =1550?: 3:?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management unsecured segment28 of the core money markets 2:, where banks conduct their transactions at great amounts% The international interbank markets do not eCist in a particular place or operate in alliance to a single set of rules, neither do they offer a single set of posted prices, with a gi4en current interest rate for money2< = IS =,9<3?: :?% +ather, they are webs of borrowers and lenders, all linked by telephones and )&Bs, and at the centre of each web is the central bank whose policies determine the short>term interest rates for that currency% Market participants in the interbank markets are banks which are either lenders or borrowers =(ikman =155<?: <?% 6et, the maHor criteria for participation are that the banks establishes itself as suitably creditworthy in the eyes of the other banks and that it is not constrained by regulatory obstacles 29 = IS =,9<3?: :?L $e4inson =1550?: 3<?L Madura =1555?: ,3:?% *nown ?s"ect of #anking International Interbank transactions are a known aspect of banking% (ccording to Franklin et al =155<?, in modern financial systems, interbank markets play at least two 4ital roles% )rimarily, it is in such markets that central banks acti4ely inter4ene to guide their policy interest rates, hence this will be further elaborated on in chapter 8 =Franklin et al =155<?: ,?% -e4ertheless, central banks plays a crucial role in the interbank markets, as they operate as granting short term collateralised loans05 to banks, which deposit the loan proceeds at the central bank% It is the task of the banks to redistribute the li@uidity through the money market to balance li@uidity supply and demand on an ongoing basis% It can be stated that the central bank li@uidity is the current account 0, of the banks deposited at the central bank% Thus, as the recent turmoil resulted in a reluctance of redistribution of li@uidity by banks, the function01 of central bank became much more significant in order for maintaining the function of the international interbank markets as the banks re@uire central bank li@uidity for their interbank
46 47

See (ppendiC 8, for the most well known secured and unsecured segment de4elopments in the money markets% Money market instruments are issued when e4er eCperienced a temporary shortage of cash, and due to the fact that money markets ser4e businesses, the a4erage transaction siFe is 4ery large =Madura =1555?: ,3:?% There are se4eral types of money market instruments which are issued in the primary market =The primary market is referred to the initial offering of a security i%e% whether a stock, a bond, a loan, or a deri4ati4e instrument% Ahile the secondary market refers to the market where eCisting securities can be traded between in4estors =(r4ind =,992?: ,88?? by corporations and go4ernments to obtain short term funds through sale in the secondary market =Madura =1555?: ,10?, =$e4inson =1550?: 21?% 48 +ather, they are webs of borrowers and lenders, all linked by telephones and )&Bs, and at the centre of each web is the central bank whose policies determine the short>term interest rates for that currency = IS =,9<3?: :?% 49 Such as eCchange controls or super4isory limits = IS =,9<3?: :?%
05

This collateral, usually consists of securities of high credit @uality i%e% for instance go4ernment bonds% Ahen a loan is transacted, it is credited to the account of the bank at the central bank, which in return recei4es collateral for the loan% .n eCpiry, the principal and interest are debited to the account of the bank, and the collateral is returned% Ki4en a bank is unable to repay the loan, the central bank would keep the collateral, which the central bank protect themsel4es against losses on loans =Danmarks -ational ank =155<>,%W?L 3<?% 51 I%e% the amount that the banks can use for their payments =Danmarks -ational ank =155<>,%W?L 3:?%
01

In general, central bankss pro4ide li@uidity mainly by the means of open market operations% &entral banks conduct new open market operations regularly, order to always enable ade@uate li@uidity in the banking system =Danmarks -ational ank =155<>,%W?L 3<?%

Side (6 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management payments% This, eCchange of li@uidity is illustrated by the figure below% Ki4en a ank , which ank

li@uidity re@uirement eCceeds its borrowing from the central banks% In a steady period, surplus%
3igure G G !llustration of 1i%uidity $wa"

would co4er its borrowing in the money market from ank (, which is assumed to ha4e a li@uidity

-ormal &ollateral

Turmoil Deposit

ank (
$oan $oan $oan

ank (
$oan

&entr al ank ank

&entr al ank
&ollateral

ank &ollateral $ource< 2anmarks ;ationalbank &200>-+ H)< ,9)

'ence, in a situation of turmoil, obstacles may occur in the market e%g% if ank ( constructs its own contingency li@uidity, preferring deposits at the central bank where the funds can be made a4ailable at short notice% ank ( places more li@uidity than normal at the central bank, while the central bank lends a larger amount to ank against collateral, whereby the short term money market is partly replaced by balances at the central bank% SubHect to the recent tensions in the money markets, 4arious numbers of central banks ha4e had to adHust their li@uidity management =Danmarks -ationalbank =155<>,%W?: 39?L Au =155<?: ,?L orio and -elson =155<?: 3,>31?% Secondly, well functioning interbank markets effecti4ely channel li@uidity from institutions with a surplus of funds to those in need, allowing for more efficient financial intermediation = IS =155,?: ,?L Franklin et al =155<?: ,?% 'efferman =1550? call attentions on that international interbank market ha4e become a global li@uidity distributor as well, i%e% eCcess li@uidity regions is able to pass on li@uidity to regions with a li@uidity deficit, which is subHect to the globalisation% In addition, interbank markets also became global capital distributorsL deposits placed at banks are on lent to other banks ='efferman =1550?: 88?%

Side (2 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management G + + + .ole of -oney -arket/, #enchmarks/G Interest rates at which banks eCtend short term loans to one another ha4e assumed international significance% Therefore, well established benchmarks are 4ital to the efficient functioning of the instruments in the market% 'ence, the importance of benchmarks for short term interest rates goes beyond their use in contracts% They attach the short end of the yield cur4e, and thereby con4eying information regarding eCpected future policy rates and other macroeconomic fundamentals% Money market rates are also used as a reference to terms of many financial deri4ati4es00% ( main re@uirement of a benchmark has been characteriFed as being li@uid% Mo4ements in benchmark yields should not be dri4en by order imbalances but rather only reflect new information concerning fundamentals =Aooldridge =155,?: 00?% Kyntelberg and Aooldridge =155<? further stress that benchmark yields do not necessarily need to be risk free rates% Indeed, interest rates will small credit risk premium may be more effecti4e as they reflect the rates faced by financial institutions% 6et, it is stated that the risk premium in the benchmark 08 yields is re@uired to be predictable if the yields are to be a stable reference for pricing =Kyntelberg and Aooldridge =155<?: 85?% Today, many financial instruments ha4e interest rates linked to $ibor i%e% the interest rate at which banks in $ondon offer to lend funds to each other Hust prior to ,,:55 local time 0: = (ccording to ( =1559?: :?% aba =1559? $ibor capture the rates paid on unsecured interbank deposits at large

globally acti4e banks% &urrently, $ibor is fiCed for ,0 different maturities from o4ernight to ,1 months, in ten currencies0<% ( more recent interest rate, *uribor, which is the rate at which *uropean banks lend to each other% In the /S the Fed funds rate, the rate at which banks with eCcess reser4es lend to those that are temporarily short of reser4es% Since, it is the main policy le4er of the Federal +eser4e oard, it is a 4ital economic indicator% *ach of these rates is applied solely to
03

Kyntelberg and Aooldridge =155<? highlight that the use of money market rates to price other financial instruments can be traced back to ,9:5s% The unpredictability in inflation at the time led long term fiCed rate securities unattracti4e to in4estors% Thus, in response floating rate bonds were introduced with coupon payments connected to money market rates plus a credit spread% This pricing mechanism has also been obser4ed in the syndicated loan market, which initiated to grow around the same time period =KadanecF =1552?: :8>::?%
02 00

Money market rates are referenced in se4eral financial contracts =Kyntelberg and Aooldridge =155<?: 09?%

For instance, future contracts followed by forward rate agreements and interest rate swaps were among the first to emerge% This was followed by swaptions, cross currency swaps as well to be priced of money market rates =Stigum and &rescenFi =155:?: <93><92?L Kyntelberg and Aooldridge =155<?: 85?%
08

It is notable that the benchmark status is gained through competition% Thus, it may result in a change to an alternati4e reference rate% *%g% in the /S money market in mid ,9<5s, /S Treasury bills were the pre>eminet short term reference rate, by the late ,9<5s, three month $ibor was the well established enchmark rate in the /S dollar money market =155,?: 39>2,?%
0: 0<

M(n indi4idual ( $ibor &ontributor )anel ank will contribute the rate at which it could borrow funds, were it to do so by asking for and then accepting inter>bank offers in reasonable market siFe Hust prior to ,,:55# = ( =1559?: :?% These include the (ustralian dollar, the &anadian dollar, the Danish krone, the euro, the Gapanese yen, the -ew !ealand dollar, the pound sterling, the Swedish krona, the Swiss franc and the /S dollar% -ote that similar fiCing arrangement appear in the all these markets, hence this will not be further eCplained%

Side (3 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management loans to healthy, creditworthy institutions% Thus, a bank that belie4es another bank to face credit default will charge higher interest rate or may e4en refuse to lend at all =Kyntelberg and Aooldridge =155<?: 8,?L $e4inson =1550?: 29?% .:':$ 7i;uidit Measures: 7iborB1IS Spreads This sub>section aims to describe the de4elopment of the turmoil in the international interbank markets through li@uidity measures like $ibor>.IS spreads, collateralised and uncollateralised spreads, and the term lending spreads% .n Thursday, 9 (ugust 155: traders in -ew 6ork, $ondon, and other financial centers around the world uneCpectedly eCperienced a rapid change in conditions in the o4erall money markets% Ahat began as deterioration in the /S subprime mortgage sector rapidly to other markets 09, as also mentioned in chapter 3 =IMF =155<c?: <8><:?L 'eider et al% =1559?: ,?L aba =1559d?: 12?% This de4elopment was surprising for many banks, in particular after many years of comparati4e calm =Taylor and Ailliams =155<a?: ,?% The stress in the interbank lending market became e4ident from the beha4iour of the $ibor85, which is illustrated by the figure 2%1 below, where the spread of three> month /S dollar $ibor o4er .IS during 155:>1559 is depicted% (s it can be obser4ed, this market tension was obser4ed in the maHority of the international interbank lending markets i%e% /S, euro area, /", SwitFerland, and the Gapanese market as well% 9 (ugust the initial increase in the spread has been obser4ed all o4er, though differences eCists in the increase in the basis points from market to market% G + 2 + The F$ !nterbank -arket The first @uarter of 155:, the /S $ibor>.IS spread was recorded to be < basis points, whereas on 9 (ugust 155: the three month /S $ibor>.IS spread increased to 25 basis points =Michaud and /pper =155<?: 29?L &ecchetti =155<?: 9?L 12 basis points =IMF 1559?: 2,?% aba =1559d?: 30?% (t the fourth @uarter of 155<, the spread increased to ,13 basis points, whereas in March 1559 it became 99 basis points a decrease of

59

See (ppendiC 8, for the de4elopments of the other se4erely affect core money markets%

85

The benchmark rate on interbank lending set by a eight large /" banks each morning% The $ibor lending is uncollateraliFed like the federal funds market = ( =1559?: :?%

Side (& af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management G + 2 2 The Euro-?rea !nterbank -arket /ntil 9 (ugust 155:, the unsecured euro interbank market were characteriFed by 4ery low spread around fi4e basis points, and insignificant amount of li@uidity deposit at the *& =1559?: 1?L Danmarks -ational ank =155<>,W?: 3<>39?% 6et, the fortune of the *uropean interbank market was not much different from the /S interbank market% Time Fone frictions resulted in large swings o4er the day in the demand for /S dollar interbank funds% (s *uropean banks ha4e few local sources of dollar funding, they preferred to secure funds from the interbank market early in the /S trading session% 'ence, /S banks with eCcess reser4es choose to defer lending until later in the trading day, when their net funding position became more definite% The disparity intensified the upward pressure on the /S dollar o4ernight interbank rate in *urope =&KSF =155<>-o%3,?: 2?% 'ence, as the figure also shows, the time period after the default of $ehman brothers, was characterised by crucial higher compared to the period prior to the default% (s of 1< September 155<, the spread increased e4en further to a maCimum of ,<8 basis points = IS =1559>:9th?: ,0?L 'eider et al% =1559?: 1?L Michaud and /pper =155<?: 29?L *& =1559>M Gune?: 3,?% 'owe4er, this pattern also account for the other markets, but with degrees of spreads, as mentioned abo4e% In March 1559, the euro $ibor>.IS spread became <1 basis points =IMF 1559?: 2,?% G + 2 , The F* !nterbank -arket Figure 2%1 shows that the pound sterling $ibor>.IS spread before 9 (ugust 155: has been @uite narrowed% In the first @uarter of 155: the spread has been 8 basis points, whereas in the fourth @uarter of 155< it increased to ,80 basis points, whereas in March 1559, it decreased ,15 basis points, a decrease of 20 basis points =IMF 1559?: 2,?% The euro area and the /" area ha4e de4eloped less alike the /S, where as the spread compared to the SwitFerland and Gapan has been at lower le4els% G + 2 G The Ia"anese !nterbank -arket (s the figure 2%1 illustrates the Gapanese spread has been a bit higher prior to 9 (ugust compared to the other economies% The first @uarter of 155:, the Gapanese spread has been recorded to be ,8 basis points, whereas the highest spread has been in the fourth @uarter of 155<, i%e% :3 basis points, which indicates that the default of $ehman rothers has also affected the Gapanese interbank market% The spread recorded in March 1559 shows a decrease of 12 basis points i%e% a spread of 29 basis points =IMF 1559?: 2,?% Gapanese interest rates ha4e been much lower than interest rates in the /S, *urope ='eider et al%

Side .% af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management and /"% This indicates different risk factors in the banking sectors =Taylor and Ailliams =155<a?: ,?%
3igure G / Three--onth 1ibor-0!$ $"reads of Euro, (ound $terling, $wiss 3ranc, and Jen, -arch 2007 --arch 2009

*uro

)ound Sterling

6en

(ccording to 'ui =1559? a bank 4erifies which other banks it is willing to in4ol4e itself with in transactions in4ol4ing credit risk i%e% which banks is willing to place deposits with and which it is willing to buy and sell foreign eCchange with% Ki4en the assessment of the creditworthiness of the
$ource< &9ui &2009)< 22)

other banks, the bank decides the greatest siFe of eCposure it is willing to ha4e% It is further stated that this can operate as a li@uidity constraint on co4ered arbitrage operations ='ui =1559?: 2?% (drian and Shin =155<? argue that the li@uidity constraint can be linked to the balance sheet of the financial intermediaries% It is stated that aggregate li@uidity can be understood as the rate of growth of the aggregate financial sector balance sheet% I%e% when asset price increase, balance sheets of financial intermediaries, usually become stronger and =without adHustment of asset holding? their le4erage tends to be too low% Then, financial intermediaries hold surplus capital, for such surplus capacity to be used an eCpansion of the balance sheet is re@uired% That is, on the liability side, more short term debt would increase, and on the asset side, there would be a search for potential borrowers% So, aggregate li@uidity is well connected to how hard the financial intermediaries search
Side .' af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management for borrowers% .n the other hand, when asset prices decrease during financial turmoil, the balance sheet contracts and therefore become reluctant to lend% Such beha4ior reduces the siFe of eCposure to other financial intermediaries% Such manner reduces their siFe of eCposure to other banks, then the aggregated li@uidity declines =(drian and Shin =155<?: 2?% This is the scenario that occurred in the turmoil from 155:>1559, where asset prices declined, and the balance sheets of banks contracted, which made banks reluctant to lend in the interbank market as well as in the rest of the money markets% (s a conse@uence, this reduced the funding li@uidity, and re@uired higher risk premiums i%e% greater aggregate price of risk, for lending with longer maturity% Furthermore, this reluctance to lend to each other in the interbank market at longer maturity contributed to the considerable rise in spreads between $ibor and the o4ernight indeC swap =.IS? rates in the /S and euro area, /" and Gapan in (ugust 155:% (nd as it can be seen the spreads persisted at high le4els during the financial crisis until 1559% /nder normal conditions, the .IS rates tend to mo4e 4ery closely to the corresponding currency $ibor, and thus the spread between $ibor and .IS is less than ten basis points% ut what does the $iborJ .IS spread tells usI This is probably best eCplained by (lan Kreenspan =1559?, former Federal +eser4e &hairman who states that 61ibor-0!$ remains a barometer of fears of bank insolvency = (s the $ibor is the rate at which banks indicate they are willing to lend to other banks for a specified term of the loan, the .IS8, rates is eCpected future o4ernight rates for the following two reasonsL ,?the counterparty risk related with the .IS contracts is relati4ely small due to no principle is eCchanged% In addition, the residual risk is alle4iated by collateral and netting agreements% 1? the li@uidity risk premia in4ol4ed in .IS rates is assumed to be 4ery low due to lack of any initial cash flow =Michaud and /pper =155<?: 29?% In the literature, the $ibor>.IS spread is a standard measure indicator of funding risk in the term interbank market =(llen and &arletti =155<?: 2?L 'eider =1559?: 1?L SchwarF =1559?: 0?L IMF =155<c?: ,,5?L IMF =1559>/pdate?: ,?L *isenschmidt and Tapking =1559?: :?L 'ui =1559?: :?%

8,

In such a contract, two parties agree that one will pay the other a rate of interest that is the difference between the term .IS rate and the geometric a4erage the o4ernight federal funds rate =each country has a similar rate? o4er the term of the contract% The term .IS rate is a measure of the eCpectations of the market due to no eCchange of principle, i%e% funds are eCchanged only at the maturity of the contract, when the party pays the net interest obligation to the other =Thornton =1559?: ,?%

Side .$ af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management .:':( Secured and #nsecured Spreads 'owe4er, Taylor and Ailliams =155<ab? stress that another 4ery good measure of interbank risk is the $ibor>+epo =go4ernment? spread as it is the difference in rates between secured and unsecured lending between banks at the same maturity =Taylor and Ailliams =155<b?: 8?L Taylor and Ailliams =155<a?: ,1?L Taylor =1559?: ,5?% 'ence, due to the una4ailability to loomberg, there ha4e been no possibility to eCtract the needed data, and this thesis has been restricted a4ailable publications with the newest possible data% Therefore, this section will also describe the $ibor>+epo spreads, in order to draw a more coherent conclusion% Interbank markets, were weathering a time period, where considerable uncertainty about the @uality of bank loans and their other assets resulted in uncertainty regarding creditworthiness of counterparties% &oncerns related to credit conditions resulted to deep and persistent li@uidity crisis% (s a result, the spread between unsecured and secured short term interbank financing rates widened radically, as shown in the figure 2%3 below% The spread widened from a few basis points to 05>,55 basis points in (ugust 155:% In particular the widening for /S dollar and pounds sterling were highest compared to euro, which eCperienced a spread of a bit more than 05 basis points%

Side .( af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Figure 2%8 $"reads between $ecured and Fnsecured Three--onth 2e"osit .ates

$ource< &2anmarks ;ationalbank &2009-H+)< G7) -ote: The rate of interest on a 3>month interest>rate swap has been applied as the collateralised rate% The most recent obser4ations are from 3 March 1559% )lease, ignore the red line%

'owe4er, the greatest spread has been obser4ed in the fourth @uarter of 155<, which is e@ui4alent with the bankruptcy of the $ehman rothers% *specially, the spread in the /S dollars increased rapidly, to approCimately 385 basis points, whereas the spread between secured and unsecured three month deposit rates for pound sterling and *uro was lower compared to the /S dollars, around 105 basis points and around 155 basis points, respecti4ely% (lbeit, with the entrance of year 1559, the spreads ha4e terminated down to spreads around ,55 basis points for *uro and /S dollar, whereas the spread for pounds sterling has been higher compared to the other two currencies% *Camining further the differences in maturities, the below figure 2%2 depicts the de4elopment of the spread between the *uribor81 =unsecured rate? and the *urepo83 =secured rate? for the three>month, siC>month and one>year maturities% Aithin few days after the turmoil onset, the spreads increased from around ,5 basis points =bps? to around :5 =bps?, and remained at these le4els until later summer 155<% In September 155<, after the default of $ehman further to reach le4els abo4e 155 pbs% rothers, spreads increased e4en

81

*uribor has been established by the *uropean anking Federation to benchmark in Fone rates, which applies a concept of country @uota% *ach in> country has at least one bank represented on the )anel and smaller countries will rotate membership of the )anel amongst their leading commercial banks e4ery 8 months% Today, *uribor has a panel of 29 reference banks from in Fone countries as well as international banks% ank of Tokyo> Mitsubishi, &hase, &itibank, G) Morgan ank of (merica and / S represents the international banks% The a4eraging method of ( $ibor and *uribor is @uite similar, although solely the top and bottom ,0 per cent are reHected in the process% Thus, the difference in topping and tailing will result in being a greater ratio of smaller banks to larger banks in *uribor =www%bbalibor%comJbba: 1559?%
83

The *urepo represents the an a4erage general collateral =K&? repo rate from euro repo transactions =www%eurepo%org?

Side .. af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

Figure 2%: $"reads between $ecured and Fnsecured Three--onth 2e"osit .ates

$ource< Eisenschmidt and Ta"king &2009)< 29) -ote: The darkest lines, is the one>year maturity, the light line is the siC>month maturity, whereas the dotted line is three months% It is to be mentioned that the dis>clarity relies in the source the chart has been originated% *isenschmidt and Tapking =1559? highlight another 4ital obser4ation i%e% to

end of @uarter effects in

the market during the turmoil% For instance, the one>month *uribor =unsecured? spreads has been higher in the last month of each @uarter, in particular in the last month of 155:, in contract to other months since the onset of the turmoil% &orrespondingly, the one>week *uribor spread has also been higher in the last week of each @uarter than in other weeks% *& =155<>Gune? emphasise that close to the year or @uarter ends, or the end any other important financial reporting period, institutions often attempt to impro4e their apparent financial health preparation for public disclosure of their accounts, also known as window dressing This is eCecuted, in order to impro4e appearance to shareholders, analysts or, in the case of financial firms, e4en to ensure that regulatory re@uirements% In particular, financial firms may reduce their credit eCposure and increase their li@uidity position% Furthermore, it is stated that concerns related to window dressing can lead to increased li@uidity risk as many banks reduce their lending when engaged in these abo4e mentioned acti4ities, which is reflected in the increase in o4ernight rates as the year>end or @uarter>end come near =*& =155<>Gune?: :<?% ( 4ery important obser4ation is the great spread between the one year and three>month rates, which indicates that banks seem to raise funds repeatedly at shorter maturities in the unsecured market compared to longer maturities, and in this case at one year and siC month maturities% The spread in

Side .5 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management the fourth @uarter of 155< is in particular 4ery high% Spreads between one year maturities reached around below 105 bps%, siC months around 155 bps%, while three>month was around ,:5 bps% (nalysing the maturity situation further, according to *& =1559mm? the unsecured market

remained mainly on o4ernight market% In the second @uarter of 155< o4ernight acti4ities represented around :5 per cent of the total lending and borrowing acti4ity in the *uropean unsecured market% *& =1559>*MMS? states that 98 per cent of unsecured transactions appeared at maturities of less than one month in 155<% In general, the credit risk associated with unsecured operations leads banks to limit their unsecured transactions in longer maturities% .n the borrowing side, the eCposure in the o4ernight segment declined from ,, per cent to < per cent of total eCposure while the proportion in maturities abo4e one>month increased% Ahile, the lending side, there was a significant decrease in eCposure with maturities longer than three months, in particular for one year maturity, which decreased from 15 per cent to 9 percent of total eCposure =*& =1559mm?: ,2?% *isenschmidt and Tapking =1559? argue that banks can only attain funds from borrowing at the *uribor but lending at funds at *uribor is hardly possible as prime banks prefer to borrow repeatedly o4ernight at the low unsecured o4ernight rates rather than for a longer period at the higher *uribor =*isenschmidt and Tapking =1559?: ,8?% This reflects that in a period of ele4ated li@uidity risk or funding risk, banks choose to lend li@uidity short term in the unsecured market rather than long term due to the uncertainties of funding defaults% .:':. )redit Measures: )-S Spreads This second part of the first main parts aims to describe the credit default swap spreads for the maHor economies% It is to be noticed that the fi4e year bank credit default spreads for selected Gapanese banks were not possible to be obtained, and therefore it is omitted in this subsection% G + G + 3ive- Jear #ank '2$ $"reads for $elected #anks
efore, eCamining the de4elopment in the &DS spreads for selected banks, there will be a brief description of a &DS, which intends to gi4e a better understanding of why it is applied as a credit measure in the literature%

&redit default swaps82 are insurance against credit risk, it is a contract that guarantee to co4er losses on certain securities in the e4ent of a default% ( &DS is a bilateral agreement between two parties, a
82

$ately, many institutions ha4e engaged in trading with credit risk, and one of the most widely used are credit default swaps, &DS, a type of insurance contracts% The notional amount of outstanding &DS has increased from N32,2 trillion in December 1558 to N81 trillion at year end 155:, and thereby decreased to N3<,8 trillion at year end 155< =www%isda%org =1559?: 11 (ugust 1559?%

Side .6 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management buyer and a seller of credit protection% The seller compensates the buyer if the issuer fails to ser4ice the debt holding =such as bonds, notes, loans and commercial papers?, which has been issued by a third party, called the reference entity% .ne of the parties agreement purchases, for an agreed period, protection against a credit e4ent i%e% the case when the reference entity default or failure to meet its payment obligations% Ki4en that the reference entity defaults or fails to meet its payment obligation the contract must be settled i%e% the buyer recei4es the difference between the 4alue of the asset and its nominal 4alue% Most of the &DS has a maturity of fi4e years = omfim =1550?: 89?L Danmarks -ationalbank =155<>W3?: ,53>,52?% The insurance premium of a &DS is called the credit default swap premium or the &DS spread% The spread is @uoted in basis points per annum of the contracts notational 4alue and is generally paid @uarterly =(delson =1552?: 3?% In the literature, a range of authors ha4e agree on to identify the attribution of counterparty risk, credit default swaps spreads are used to measure the default risk of the banks i%e% the probability that banks may default on their debt ='ui =1559?: ,,?L IS =1559abc?: 2<?L IMF =1559>/pdate?: ,?L Taylor and Ailliams =155<a?: 8, ,<?L *isenschmidt and Tapking =1559?: 19?% Therefore, in this thesis this measure will also be used as an indicator of the default risk that has appeared in the markets%

Side .2 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Figure 2%< 3ive-Jear #ank '2$ $"reads for $elected #anks, 2007-2009

Figure 2%0 abo4e illustrates two maHor rapid rising in the fi4e> year &DS for se4eral maHor financial institutions in /S, *uro area and the /"% The initial increase can be obser4ed already in Guly of 155:, but the spread was less than ,55 basis points% 'ence, the first maHor increases occurred in the first @uarter of 155< for all the economies, but the /S spread was higher =around 195? compared to the *uro area and /", which were less than 155 basis points% $ooking at the market de4elopments, 15 March, 155< earn Stearns faced li@uidity shortage, and bailout of ear Stearns and G)Morgan &hase, seems to play a role behind the high &DS spread in /S = IS =1559abc?: 2, ,:, ,,5?% *Camining the second and the greatest spread that approCimated 855 basis points, no doubt the $ehman brothers default played a role in the spread, whereas in the *uro area and /" the spread increased a bit more than 155 but less than 355 basis points% 4.2 %nternational )* "+ap Mar(ets

$ource< &!-3 &2009-u"date)<+) -ote: in basis points

(s mentioned earlier in the chapter, this section intends to describe the international FX swap market% Therefore, the first part of this chapter aims to gi4e a brief introduction to the international FX swap market, and thereafter describe the tension de4eloped in the market 4ia li@uidity measures% *4ery country prices are eCpressed in units of currency, either issued by the central banks of the countries or a different one in which indi4iduals prefer to denominate their transactions% In order to Hudge the 4alue of the currency itself, eCternal reference is re@uired i%e% the eCchange rate% Determining the relati4e 4alues of different currencies is the task of the foreign>eCchange markets 80 =$e4inson =1550?: ,2?% (ccording to
80

IS =155:? the a4erage daily turno4er in traditional foreign

Since, ancient times, foreign>eCchange has eCisted, and has flourished or diminished depending on the eCtent of international trade and the monetary arrangements of the day =*inFig =,981?: ,,>15?% In particular, along with market forces determining eCchanges =note: after late ,985s, the agreement of the retton Aoods system i%e% eCchange rates based on fiCed rates, started to break down and in ,9:1 the go4ernments of the largest economies decided to let market forces determine eCchange rates, which resulted uncertainty about the le4el of eCchange rates, see Monetary &ontrol (ct of ,9<5 in the /%S% =$e4inson =1550?: ,2,,<??, ha4e led to dramatic growth in currency trading%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management eCchange markets to be N3%1 trillion in 155:, which is growth of 89 per cent since (pril 1552, and therefore is also one of the most li@uid markets = IS =155:n?: ,?% The foreign eCchange markets consist of four different markets88 which function separately, yet are 4ery closely connected% 6et, most foreign eCchange trading 8: occurs in the deri4ati4es market% In principle, the term describes a large number of financial instruments, as well as options and futures, while in general practice, it refers to instruments such as forwards contracts, FX>swaps, F+(s, and barrier options =$e4inson =1550?: ,2>,:?% More than half of the increase in turno4er accounts for by the growth in FX swaps, which increased <5 percent compared with 20 per cent o4er the pre4ious three year IS =155:n?: ,?% Se4eral factors ha4e been presented in the literature for the ongoing growth in this segment% The fact that FX markets offer in4estors with short term horiFons, @uite attracti4e risk adHusted returns on the year, gi4en the fact that financial markets 4olatility was at historically low le4els has been one of the reasons% (dditionally, longer term in4estors such as pension funds ha4e also contributed to the increase in turno4er by di4ersifying portfolios internationally = IS =155:n?: 0?L Kalati and 'eath =155:?: 80?% Subse@uent to the core money markets were hit by the turmoil in the second half of 155:, there has been obser4ed a spill o4er to FX swap and cross>currency swap markets as well = aba et al% =155<?: :3?L o* =155:?: ,<?L aba 7 )acker =1559?: ,?% Ahen dealing with foreign currencies, a bank is eCposed to the risk that a uneCpected change in foreign eCchange rates or market li@uidity, or both, could stridently widen the li@uidity mismatch being run = asel "omiteen =1555?: 15?% Thus, gi4en the fact that FX and related deri4ati4es market are some of the most li@uid markets = aba et al =155<?: :3?, and gi4en the fact that from mid>(ugust to mid>September, trading li@uidity in the FX swap market was se4erely impaired, it is crucial to in4estigate the effect of the turmoil in these markets and possible factors behind it =Federal +eser4e ank of -ew 6ork =155:?: ,5?% .:$:' 7i;uidit 0isk MeasureB FX Swap Spread In the academic literature, it is stated that the FX swap spread that represents the premium or discount is reflected in the Swap implied /SD funding rate i%e% the de4iation from &I), which is calculated from the $ibor>.IS spreads for the foreign currency and /SD respecti4ely ='ui =1559?:
66

These are the followingL the spot market, the future market, option market, and the deri4ati4e markets =$e4inson =1550?: ,0?%

8:

In most conditions, foreign eCchange trading is 4ery much connected with the trading of securities, in particular bonds and money market instruments% (n in4estor who belie4es that a particular currency will appreciate will not want to hold that currency in cash form, as it will earn no return% (s an alternati4e, the in4estor will buy the preferred currency, in4est it in highly li@uid interest>bearing assets, and then sell those assets to obtain cash at the time the in4estor wishes to sell the currency itself =$e4inson =1550?: ,2>,:?%

Side .& af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management <?L aba et al =155<?: :<?L aba and )acker =1559a?: <?% It is further highlighted that the FX swap spread is a measure of the funding li@uidity risk = aba et al =155<?: :3?L 'ui =1559?: <?% Moreo4er, it is necessary to state that to identify the attribution of counterparty risk to the de4iations from &I), credit default swap =&DS? spreads are applied to measure the default risk of the banks in the /S, the euro area, the /" ='ui =1559?: ,,?L aba and )acker =1559a?: <?% 'ence, as this has already been described in section G + G +, see kindly section G + G +% Therefore the following will only describe the de4elopment in the FX swap spread for the following currencies, /SD dollars, *uro, pound sterling, yen during the turmoil period% From the start of the turmoil in (ugust 155:, there emerged a spread between the short term FX swap implied dollar rate, across a number of funding currencies, and the corresponding dollar $ibor rate, as illustrated in figure 2%8% This remarkable pricing beha4iour re4ealed 4ital and constant departure from &I)% In normal time period, the FX swap spread is efficiently arbitraged and close to Fero for most currency pair i%e% &I) holds ='ui =1559?: 3?L aba and )acker =1559?: 2?L aba et al% =155<?: :9?% (ccording to abe et al =155<? the FX swap>implied dollar rates from the euro and sterling mo4ed Hointly @uite closely with dollar $ibor% $ooking for yen, the spread was negati4e in the first @uarter of 155:, for the three month maturities =note: as can be seen from the figure, this is also the case for siC month maturity, and then a slight positi4e reaction occurred but ne4er ranged beyond 0>,5 basis points% Thus, suggest that &I) broadly was not de4iated for these currency pairs in the period pre4ious the turmoil = abe et al =155<?: ::?% Figure 2%8 illustrates how much the three> month, siC>month and ,1> month /S funding rate implied from the FX swaps in */+, K ) and G)6 de4iates from the corresponding $ibor i%e% the risk premium demanded by dollar lenders in the swap market, or in other words the departure from &I) during 9 (ugust 155: to 3, March 1559%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Figure 2%9 $"read between 34 swa"-im"lied rates and 1ibor

*/+

K )

G)6

$ource< 9ui &2009)< 2+)

(fter 9 (ugust for three currencies an upward trend was obser4ed, the spreads between the FX swap>implied dollar rates and dollar $ibor also increased, mo4ing from Guly le4els, i%e% close to 30 basis points in the euro, 10 basis points in sterling, and ,0 basis points in the yen% (necdotal e4idence suggest *uropean financial institutions that needed /S dollars, hence faced keen concerns o4er their own credit risk in dollar cash markets, turned to the FX swap market to raise dollars using both the euro and sterling as funding currencies = aba et al =155<?: :<?L aba 7 packer =1559b?: ,?% It is further stated that mo4ements in the FX swap price de4iated from &I) conditions may ha4e reflected a shift towards one sided order flow in the FX swap market with
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management li@uidity further deteriorated subHect to the fact that institutions intensified in@uest for counterparty risk were concentrated on the dollar borrowing side of the market as well% 'ence, another eCplanation has been that the reported $ibor has been fewer representati4es of actual interbank rates during distress instant, and the gap may ha4e been greater for dollar $ibor than $ibor for other currencies% +egardless, the FX swap implied dollar rates appeared more sensiti4e to the increased demand for dollar funding than reported dollar $ibor rates 8<% -e4ertheless, the le4el of di4ergence from &I) has been recorded to be smaller than in the case of the euro and sterling, e4en the FX swap implied dollar rates from the yen showed a degree of de4iations, signifying that FX swaps in yen has also been used in heightened 4olumes to secure dollar funding% = aba et al =155<?: :<?% The greatest increase in the FX swap spread increased in the fourth @uarter of 155<, which is similar to trend obser4ed in the other figures seen in the pre4ious sub>sections% (nother analogous character obser4ed is that this spread has been highest for three month maturities, and then siC> months compared to the one year maturities% This also reflect that market participant ha4e seeked for short FX swapping rather than longer maturities% In early September and onwards to the year> end, there ha4e been anecdotal reports of selected *uropean financial institutions with access to the yen FX swap market swapping great amounts of yen into dollars to meet their dollar funding needs, which eCplains the maturity preferences obser4ed in the figure abo4e% Furthermore, market participants ha4e also implied that Gapanese banks, eCpected an increased demand of *uropean financial institutions in the yenJdollar FX swap market, showed efforts to secure the necessary dollar funding 4ia FX swap ahead of the fiscal half year end =September? and calendar year end = IS =155:n?: ,2, ,8>,:?L aba et al =155<?: :9?L *uropean &entral ank =155:?: 25?% eginning in -o4ember and December, the spread between the FX swap implied dollar rate from yen and dollar $ibor became @uite minor compared to other FX swap market, indicating that the confidence in the yen swap market to fund demand for dollar li@uidity had greatly declined by then% This decline has partly been due to the rigorous measures by central banking society to ease li@uidity concerns in the markets = orio 7 -elson =155<?: 39?L aba et al =155<?: :9?% 6et, as of

8<

It is to be remarked that, obser4ing intraday mo4ement of FX swap implied dollar rates would ha4e presented a deeper insight into the /S dollar funding needs, hence intraday cash rates consistent with the intraday FX forward discount rates ha4e not been a4ailable = aba et al =155<?: :9?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management end>Gan, there were eCpectations of renewal demand in swap market for dollar li@uidity later in 155<, especially through the euroJdollar and yenJdollar pairs = IS =155:n?: ,0?% -e4ertheless, Hust like in the pre4ious figures with the -ew 6ear, 1559 the spreads has decreased to almost le4els seen in the beginning of 155:, which reflects a degree of reco4ery in the market% The possible eCplanations behind this reaction will be discussion in chapter 0%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

)/A*T+0 5:

+M*I0I)A7 A,A7?SIS & -IS)#SSI1,

The last main part of the thesis has described the de4elopment financial turmoil in the international interbank and the FX swap markets from 155: to 1559% The obHecti4e of this chapter is to analyse and discuss the empirical frameworks in the light of the applied theories and the presented statistics in the pre4ious chapters% Identifying the underlying factors is @uite important, in analysing the de4elopment of the main central banks inter4entions in these markets, and its effecti4eness% Therefore, this chapter is to be percei4ed as a link to the following chapter, where the central banks actions and effecti4eness are analysed% !.1 %nternational %nterban( Mar(ets The aim of this section is initially to analyse the factors that triggered the tensions obser4ed in the international interbank market as seen in chapter 2 i%e% the $ibor>.IS spreads and &DS spreads% Thereafter there will be a discussion of the underlying factors behind the widened spreads obser4ed in the interbank markets% 5:':' Factors tri!!ered the Tension in Interbank Markets .ne of the main responsibilities of interbank markets is to reallocate li@uidity among banks that are subHect to particular distress% If banks hoard li@uidity and as a result they are able to co4er the particular distress from their own li@uidity holding, then their unwillingness to lend to other banks is not an issue% 'ence, if, the li@uidity hoarding pre4ents the reshuffling of li@uidity to deficient, but sol4ent banks, then the poorly functioning interbank market would be a issue warranting central banks pro4ision =(llen and &arletti =155<?:1?L hattacharya and Kale =,9<:?: 8?L hattacharya and Fulghieri =,992?: 1<<>1<9, 19,>191?% (s illustrated in chapter 2 =&DS spreads?, credit and li@uidity =$ibo>.IS spread? risk increased as market participants became worried about their counterparties a4ailability and funding possibilities, and as a result banks became reluctant to lend to each other% 'ieder et al =1559? stress the significance of lack of supply in the market breakdown, and therefore li@uidity hoarding is eCamined here as the market has the banks engaged in such an acti4ity ='ieder et al =1559?: 13?% 1i%uidity 9oarding (s illustrated in figure 2%1, the spread between the three>month $ibor and the .IS increased, but this increase had an effect on the amount of li@uidity parked by banks at the *& % The time period from 9 (ugust 155: to 1< September, there was not obser4ed large amounts of funds parking at the *& , eCcept the 155: year>end effects% 'owe4er, as of 1< September 155<, along with 4ery high
Side 5. af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management increased spreads i%e% ,<8 basis points see figure 0%,, a dramatic increase in the amounts of banks brought to the *& % The *& , Fed and o* impose an a4erage reser4e re@uirement on banks i%e% banks must maintain a certain a4erage minimum deposit at the central bank for a reser4e maintenance period of around one month in the *& and o*89, and of two weeks in the Fed:5% The purpose is to stabilise the o4ernight interest rate% This gi4es the banks an incenti4e to lend li@uidity in the money markets when the o4ernight interest rate is high in contrast to the interest rate on deposits in reser4e re@uirement accounts% (lternati4ely, the banks ha4e an incenti4e to maintain ample reser4es in periods when the o4ernight interest rates are low% =Danmarks -ational ank =155<>,W?: 39>25?L &ecchetti =155<?: :><?% Thus, banks prefer to lend out eCcess cash since the rate offered by the o4ernight deposit facility of *& is penalising relati4e to rates a4ailable in interbank markets ='eider et al% =1559?: 1?L Danmarks -ational ank =155<>,W?: 3<>39?% 'eider et al =1559? stress that the amounts increase more than ,<55 fold between the week of , September 155< and the week of 19 September 155<% (s the figure also depicts, the amounts deposited with the *& rose from a daily a4erage of X5%59 billion in the week beginning , September 155< to X,89,2, billion in the week of 19 September 155< ='eider et al =1559?: 1?%

89 :5

&oncerning the o*, the banks ha4e the possibility to themsel4es to determine, within certain limits, the siFe of their reser4e re@uirements and change them from month to month =Danmarks -ational ank =155<>,W?: 39>25?% The re@uirement is calculated as a percentage of the two>week a4erage of balances on deposits with unlimited withdrawal pri4ileges% The re@uirement is adHusted, with the first few million dollars in deposits eCempt, then three percent on the neCt N20 million or so, and ,5 per cent on amounts abo4e that% It is to be remarked that balances are not remunerated i%e% interest rate is Fero, therefore eCpensi4e to hold, so banks economise on the need to hold them% anks choose to apply compleC algorithms to shift funds in and out of accounts with limited withdrawal benefits that do not attract a reser4e re@uirements, which makes the reser4e re@uirement irrele4ant =&ecchetti =155<?: <?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Figure 0%, !nterbank $"read, .ecourse to the E'# 2e"osit 3acility, and 1i%uidity ?bsorbing 3ine Tuning 0"erations, ?ug 200>-;ov 200>

The amounts deposited with the *&

were triggered by the collapse of Aashington Mutual, ten

days after the $ehman failure, ,0 September 155<% This also shows a sharper market reassessment of risk in the summer of 155:, after subprime mortgage backed securities were disco4ered in portfolio were disco4ered in portfolios of banks, which led to a further increase in the le4el and dispersion counterparty risk the e4ents in September 155<:, ='eider et al =1559?: 3?% -ote: the Fineof Tuning .perations will be following further elaborated on, in chapter X The last weekend of September 155<, banks started to hoard their own li@uidity and parked it at the *& rather than lending it out i%e% banks started to store more funds than actually necessary to satisfy the reser4e re@uirement, also meaning that banks became reluctant to lend to each other i%e% the credit risk increased as they became worried about whether the counterparty were able to repay the loan ="empa =155<?: :?L =IMF =1559?: 2,?L =Aorld ank =155<?: 88?L =FreCias=1559?: 0?L = IS =1559>:9th? 1:?L =Danmarks -ationalbank =155<>,W?: 29?L =Michaud and /pper =155<?: 2:?L =&KFS =155<?: 2?% This beha4iour reduced the efficiency of the interbank market in the distribution to banks that needed funding% This situation pa4ed the way to the announcement of the *& , on < .ctober 155< stating a change in its tender procedure and standing facility corridor% The Fed also conducted a similar action, which is eCplained in further details in chapter 8% In 9 .ctober 155<, the deposit facility rate was increased from ,55 to 05 basis points below the policy rate, therefore making deposits relati4ely more attracti4e% The marginal lending facility rate was reduced from ,55 to 05 basis points abo4e the policy rate i%e% 2%:0 per cent =*& =155<>)+ < .ct?: ,?% In addition, from the operation settled on ,0 .ctober 155<, through the weekly main refinancing operation carried out 4ia a fiCed rate
71

$ource< &9eider et al &2009)< 2G)

MaHor dramatic e4ents was surrounding the last weekend of September 155<% For instance, before the weekend of 1:>1< September, Aashington Mutual, the largest S7$ firm in the /S was seiFed by the FDI& and sold to G) Morgan &hase =FDI& =155<?: ,?% .4er the weekend, it was announced that ritish mortgage lender radford 7 ingley had to be rescued =+euter =155<?: ,?% Furthermore, eneluC announced the inHection of X ,,%1 billion into Fortis ank =Ko4ernment of -etherlands =155<?: ,?% (nd on the following Monday, Kermany reported the rescue of 'ypo +eal *state and Iceland nationalised Klitnir =Financial Market StabiliFation Fund =SoFFin? =1559?: ,?L 'eider =1559: 13?%

Side 56 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management tender procedure with full part at the policy rate, *& =155<>)+,0 .ct?% Meantime, as the figure 0%1 below also illustrate, banks began to bring funds to the *& , the a4erage daily 4olume in the o4ernight unsecured interbank market =*onia? hal4ed and the net amount of central bank li@uidity outstanding decreased rapidly% (t the start of the crisis in (ugust 155:, the *onia increased in 4olume% The year prior to 9 (ugust 155:, the a4erage daily 4olume was recorded to X 25%9, billion, which increased by 1: per cent to an a4erage of X01%,1 billion between 9 (ugust 155: and 18 September 155< ='eider et al =1559?: 12?%
3igure / 2 ;et $tock of 'entral bank 1i%uidity 0utstanding &left scale) and overnight unsecured market volume &right scale), ?ug 200>-;ov 200>

was satisfying demand for li@uidity =*&

The net amount of central bank li@uidity outstanding shown in the figure abo4e, is the total stock of li@uidity pro4ided minus the amount absorbed in all open market operations and recourses to its standing facilities% $ource< &9eider &2009)< 2/) Moreo4er, a similar trend the figures illustrate is that, although the *& pro4ided large amounts of li@uidity during September 155<, banks were not depositing funding until the end of the month% 'eider et al =1559? emphasise that, there is e4idence that the number of banks participating in the li@uidity absorbing operations of the *& is the not the same as the range of banks participating in its li@uidity pro4iding operations% Therefore, as of the last weekend of September 155<, banks were hoarding their own li@uidity and depositing it at the *& rather than lending it out% In addition, 'ieder et al =1559? stress those safer banks left the unsecured market as they ha4e alternati4e to obtain li@uidity than riskier banks% It is further stated that this is in according with anecdotal

Side 52 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management e4idence about the reluctance of banks to borrow at high rates, in order to a4oid signaling that they are poor banks% In the literature, there is a great discussion of the underlying reasons for the tension in the international interbank market% It is 4ery significant to diagnose the underlying reason for the increased spreads as obser4ed in the market, &hapter 2, in order to determine type of necessary policy response =Taylor =1559? : ,5?, which is discussed in chapter 8% Therefore, this section aims to eCamine the underlying reason behind the spreads obser4ed in the international interbank market in the theoretical frame i%e% the role of credit and li@uidity risk% 5:':$ )redit and 7i;uidit 0isk Kenerally, 6there should be an arbitrage that allows a bank to borrow overnight, lend for three months, and hedge the risk that the overnight rate will move in the federal funds futures market leaving only a small residual level of credit and li%uidity risk that accounts for the small s"read observed before the beginning of the crisis ? relevant %uestion is why banks were unable to do so= =&ecchetti =155<?: 9?% In the literature, there seems to be a degree of uncertainty of the underlying dynamics behind the obser4ed spreads in the international interbank markets% *mpirical work on decomposing risk spreads has generally found greater role for credit risk = eber et al =1558?: 3?L $ongstaff, Mithal and -eis =1550a?: ,<?L Mc(ndrews, Sarkar and Aang =155<?: 2?% =Flannery =,998? focuses on credit risk under asymmetric information, illustrating how ad4erse selection may lead to break down of the interbank market =Flannery =,998?: <,,>,1?% =Taylor and Ailliams =155<a? is also one of those authors who pro4ide e4idence that credit risk is predominant in the turmoil in the international interbank markets with more newer data =Taylor and Ailliams =155<a?: 33?, whereas Taylor and Ailliams =155<b? stress that counterparty risk is a main eCplanation behind the spreads on term lending rates =Taylor and Ailliams =155<b?: 15?% This has been supported by a more recent study, where Taylor =1559? stress that he inter4iewed traders who deal in the interbank market, and many trader and monetary officials eCpressed their thoughts as the main problem relied in li@uidity matters% 'ence, the empirical work suggests that the spread between the unsecured and secured interbank rates and $ibor>.IS spreads cannot be eCplained merely by li@uidity problem of the kind that could be alle4iated merely by central bank
Side 53 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management li@uidity tools% +ather, it has been suggested that it has been an inherently a counterparty risk matter, which is connected to the underlying cause of the financial crisis, as eCplain in chapter 3 i%e% a fundamental problem in the financial sector relating to risk% Taylor =1559? further states that the turmoil is not like the Kreat Depression where printing money or pro4iding li@uidity is the solution =Taylor =1559?: ,5?% 'owe4er, there is also a range of e4idence academic literature that apply the Diamond and Dyb4ig =,9<3? approach, which generally focus on li@uidity risk as an factor for breakdown of interbank market% The role of li@uidity has also been documented by studies focusing on intraday patterns of traded 4olumes and interest rates in the interbank market = aglioni and Monticini =155<ab?: <>9, 9?% (lthough, there is an uncertain about the eCplanation behind the tension eCperienced in the international interbank market% Still, there is an upcoming e4idence documenting the both risks i%e% li@uidity and credit risk in the recent turmoil% Duffie et al =1553?, $ongstaff et al =1550? argue that both credit and li@uidity concerns are critical components of eCplaining the spreads = eber et al =1558?: 3?L $ongstaff et al =1550a?: 1128>:?% More recent studies, like aglioni =1559? also argue that both elements play a rele4ant role, and aglioni

support the 4iew that the interplay between the two sources of risk should be eCamined%

=1559? further stress that if li@uidity were the only eCplanation for the turmoil, central banks should ha4e been able to @uickly restore normal conditions in the interbank markets, by inHections of great amounts of li@uidity and making the supply of bank reser4es meet the le4el demanded by the banking system, or neither sol4e issues related to the creditworthiness of counterparties% 'ence, as so far this has not been a solution% Moreo4er, if credit risk were the only eCplanation, it would be difficult to eCplain the noteworthy differences across market segments, especially why the short term segment has been rather resistant from the crunch, and why banks should lend short term at normal rates, if it its belie4ed that counterparty may not be able to repay = aglioni =1559?: 1, 8, ,9? orio =155<? also emphasise the role of both credit and li@uidity risk in the recent turmoil in the interbank market% It is stated that as banks began to hoard li@uidity and became reluctant to lend to each other, as mentioned earlier, the risk premium reflect a combination of li@uidity and counterparty credit risks, in an eCtent which is hard to separate in the eCplanation of the tension orio =155<?: :?% runnermeier =1559? argue that an increase in the mortgage delin@uencies due to a
Side 5& af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management nationwide decline in housing prices, and the counterparty risk in4ol4ed in this phase of the o4erall financial crisis, triggered the li@uidity crisis that emerged in summer 155: = runnermeier =1559?: 9<?% (nother author who support this 4iew is SchwarF =1559?, who find that both credit and li@uidity factors are important in eCplaining the widening of $ibor>.IS spreads, but he also stress that market li@uidity eCplains a greater share of the widening =SchwarF =1559?: 3?% Furthermore, *isenschmidt and Tapking =1559? also argue that there is e4idence that the tensions in the interbank market cannot alone be eCplained by high credit risk but, funding li@uidity risk of lenders in the unsecured term markets also plays a central role =*isenschmidt and Tapking =1559?: ,8>,<?% *& =1559>*MMS? also argue that the unsecured markets suffered dearly in acti4ity, which not

only general market li@uidity risk but also credit and funding risk concerns play a 4ital role in eCplain the declines in the unsecured markets% It is stated that many banks reduced and in some incidences withdrew credit lines they had with counterparties for unsecured transactions due to rising credit risk concerns, which was illustrated in figure 2%3, in chapter 2% Furthermore, as mentioned in chapter 0 the funding risk that certain institutions faced was due to that they had no access to li@uidity in the market, which led them to hoard additional li@uidity on their balance sheets% (s also mentioned in chapter 2, the funding sources switched from 4ery short term borrowing, where the main maHority of o4erall unsecured acti4ity usually takes place, to secured longer term instruments, which suffered from a less se4ere li@uidity strain than the unsecured interbank deposit segment% There was a general decline in unsecured transaction 4olumes, hence an increase of 3, percent in borrowing transactions for maturities longer than one month, *& =1559mm? argue that this possible indicate the increased need for some banks to obtain long>term funding =*& =1559mm?: ,3>,2?% Moreo4er, it is stressed that these abo4e matters con4erted to increasing funding costs, which contributed to augment reputational concerns% Thus, some banks including those with greater incenti4e not to disclose their cost of funding, seek for alternati4e funding sources% In some cases, these banks remedied intragroup funding, whereby some specialised institutions reduced lending to eCternal counterparties in a number of market segments in order to become li@uidity pro4iders to the group treasury function =*& =1559mm?: ,1>,3?%

Side 6% af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management !.2 %nternational )* "+ap Mar(ets

This chapter aims to in4estigate the spill o4er effect of the financial crisis in the FX swap market and thereby analyse the underlying dynamics behind the turmoil eCperienced in the international FX swap markets% Thus, the first part of this section aims to analyse the underlying dynamics behind the turmoil spill o4er from the interbank market to the FX swap market% The second part will eCamine the underlying factors of the FX swaps spread i%e% the de4iation from &I) obser4ed in chapter 2% 5:$:' Turmoil Spill over o" "rom the International Interbank Market to FX Swap Markets Mel4in and Taylor =1559? characteriFe the entrance of the crisis in the FX as 6relatively late=% In the early summer of 155:, it was apparent that se4eral markets along the money markets were hit by the crisis% (s FX market participants were watching other markets with growing ner4ousness, wondering when, if and how the market turmoil would eCtend to eCchange rates, their fears became true on ,8 (ugust 155: as the crisis spilled o4er to the most li@uid financial markets, FX markets :1, including the FX swap markets =Mel4in and Taylor =1559?: 1?L aba et al% =155<?: :3?L o* =155:?: ,<?L aba 7 )acker =1559?: ,?% Therefore, a critical element in better understanding how the crisis has spilled o4er to the FX swap market, it is essential to identify the origins behind this% Thus, this section will start will an initial description of dynamics of how the international interbank lending market affected the FX swap markets% Thereafter, the underlying dynamics behind the de4iations of the FX swap spreads obser4ed in chapter 2 i%e% de4iation of &I), will be presented, in order to assess the implemented central bank policies adopted during the crisis, which is elaborated in chapter 8% 5:$:$ - namics behind the Spill over to FX swap market (s mentioned in chapter 2, in early (ugust 155:, the o4ernight interbank in the /S and *urope came under upward pressure% Time Fone frictions led to large swings o4er the day in the demand for /S interbank funds = IS>-o%3, =155<?: 2?% aba, )acker and -agano =155<? stress that a 4ital aspect of the turbulence was due to shortage of dollar funding for many institutions = aba, )acker and -agano =155<?: :3?% The origins of the /S dollar shortage, mentioned abo4e, deri4ated from an
:1

.n this day, maHor unwinding of the carry trade =i%e% a popular strategy for currency in4estors, where a long position is taken in high interest rate currencies funded by selling low interest rates currencies e%g% in the summer of 155:, many currency in4estors were short Gapanese yen and long (ustralian and -ew !ealand dollars% (ccording to I+) the interest differential between two currencies should be offset by a change in the eCchange rates% 'owe4er, in such an e4ent, a carry trader in4estor would argue that this eCchange rate offset will not occur so the interest differential is earned and many currency market in4estors suffered great losses% Therefore, the date of the beginning of the crisis in the FX market is (ugust 155: =Mel4in and Taylor =1559?: 1>3?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management intense growth in the /S dollar assets of *uropean banks o4er the past decade that sharply outpaced the growth in their retail deposits =McKuire and 4on )eter, =155<?:33>32 L =1559?: 02?% 6et, at the same time, the usual suppliers of dollar funds to the interbank market were in an attempt to conser4e their li@uidity, due to their own growing needs and increased concerns o4er counterparty credit risk = aba =1559d?: 12?% (lready, in the summer of 155:, *uropean financial institutions tried to secure dollar funds to support troubled /S conduits for which they had committed backup li@uidity facilities =McKuire and 4on )eter, =155<?: 38?% 'ence, e4en more se4ere market strains were following the failure of $ehman rothers% (t the end of September 155<, the interbank markets were shut down, and banks sought dollar financing elsewhere =KadanecF, Kyntelberg adnd McKuire =1559?: ,9?% SubHect to this critical demandJsupply conditions in the interbank market, many non>/S financial institutions endea4oured to con4ert euro into dollar li@uidity through FX swaps, one of the most li@uid financial markets, after the turmoil started in early (ugust 155: =*& aba and )acker =155<?: 2?L IS =155<abc?: 10?% In the third @uarter of 155<, the interbank lending continued to contract, also indicating the ongoing tensions in interbank credit markets% (s illustrated in the figure 0%3 below, on residency basis, total claims on banks:3 grew by N,05 billion, after the eCtraordinary decline of more than N<55 billion in the second @uarter of 155<%
3igure / , 'hanges in 7ross !nternational 'laims, in billions of F$ dollars

=155:?: 3,?L

aba et al =155<?: :3?L

$ooking at the claims on currency basis, it can be seen that in the second @uarter of 155<, the decline in /S dollar has been much higher than the other currency, which is also in consistent with the abo4e stated regarding demandJsupply conditions in the interbank markets% KadanecF,
$ource< &7adanecA, 7yntelberg adnd -c7uire &2009)< ,0)

Kyntelberg adnd McKuire =1559? stress that the lending to other =unaffiliated? banks decreased in the third @uarter as well by N ,:3 billion%

73

Including inter office claims%

Side 6$ af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Figure 0%2 shows a reduction of the interbank lending, in particular by French, elgian and Kerman banks accounted for much of the decline% French anks reported a decline to around N105 billion, whereas Kerman banks a bit less than N105 billion% These two banks were also those with the highest consolidated foreign claims compared to the elgian banks, which only reported around N855 billion in the beginning of 155<, but suffered a decline in the foreign claims of around N,55 billion% Furthermore, only a slight decline for the interbank lending for Swiss banks ha4e been obser4ed compared to the other *uropean banks% (ccording to KadanecF, Kyntelberg and McKuire =1559?, in the third @uarter of 155<, the outstanding stock of foreign claims in other banks declined by N:22 billion =nine per cent?:2%

3igure / G 'onsolidated 3oreign 'laims, ?mounts 0utstanding, in billions of F$ dollars

In order to amidst these funding pressures, banks recei4ed li@uidity support from central banks% 'ence, this is further elaborated on in chapter 8% .4erall, *uropean financial institutions that needed /S dollars, but faced adnd delicate concerns o4er $ource< &7adanecA, 7yntelberg -c7uire &2009)< ,+) their own counterpartyJcredit risk in dollar cash markets turned to the short term FX swap market to raise dollars using both the euro and sterling as funding currencies, and thereafter to long term FX swap markets, as they realised the turmoil would last longer than eCpected, see chapter 2 figure 2%8 = aba and )acker =155<?: 3?L aba =1559d?: 12?%

5:$:( - namics behind the -eviations o" the )I* in International FX Swap Market (ccording to Taylor =,9<9? de4iations of &I) occasionally occur during periods of turbulence =Taylor =,9<9?: 3<9?% (s illustrated with the data abo4e, since (ugust 155:, the spread between the FX swap implied dollar rate and dollar $ibor rate widened significantly, reaching higher than 25
:2

'ence, the reduction of N,28 billion recorded for Dutch banks, partly reflected the sale of business units by ( - (M+.% Furthermore, more generally, the depreciation of the euro against the /S dollar reported in the third @uarter accounted for an estimated :5 per cent of the o4erall reduction =KadanecF, Kyntelberg adnd McKuire =1559?: 15?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management basis points in September 155:, which indicates a large de4iation from short term co4ered interest parity =&I)? = aba =1559d?: 12?L ='ui et al =1559?: 3?% (lthough, the spread narrowed largely immediately after 155< began, it resurged from early March% aba =1559d? and aba and )acker =155<a? stress that for &I) to hold strictly depends on negligible credit risk, li@uidity risk, measurements errors, transaction costs and political risk = aba =1559d?: 18?L = aba and )acker =155<a?: 0?L =(kram et al =1558?: 0?% In the literature, a fair amount of research has been de4oted to the empirical 4alidation of the condition and 4arious empirically studies ha4e shown that the parity condition is not always satisfied =.fficer and Aillet =,9:9?: 12<?% 6et, it is to be noticed that, there has only been conducted a limited amount of empirical research on the de4iation during the recent turmoil, and therefore, the emphasis in searching for the correct dynamics behind the de4iation in the recent turmoil will be the main purpose of this paper% 6et, the other possible eCplanation will also be included% The dynamics will be subse@uently analysed in more depth% / 2 , + 'redit .isk and 1i%uidity .isk (lbeit, as reflected in the theoretical framework in chapter 1, credit risk is not incorporated in co4ered interest parity theorem, in the literature, there is a disparity in how great role credit risk had on the FX swap spread i%e% de4iation of &I)% (dler and Dumas =,9:8? were the first authors who introduced the credit risk in the foreign eCchange market% Their model suggested that the presence of default risk on currency contracts may lead to de4iations between the forward rate and the theoretical parity rate =(dler and Dumas =,9:8?: 331?% Stoll =,9:1? is one of the first authors who presented the credit risk as the maHor eCplanation factor behind the de4iation of &I) =Stoll =,9:1?: ,,0?L ='illey et al =,9:9?L 99?% -umerous authors ha4e agreed on the default risk as one maHor eCplanation factor behind the de4iation of &I) in this recent financial turmoil% +ecent study conducted by newer data subHect to the financial crisis in the FX swap market indicates by aba and )acker =1559a? suggest that de4iations from the &I) condition in terms of the /S dollar interest rate against the euro during the crisis period from (ugust 155: to mid VSeptember 155< are significantly associated with differences in the default risk between *uropean and /S financial institutions = aba and )acker =1559a?: ,1?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management (nother study conducted by aba and )acker =1559b?, again related to the recent turmoil in the FX swap market, find that the de4iation from &I) in the *uro FX swap market has been due to reassessment of counterparty risk based on the data from (ugust 155: to September 155< = aba and )acker =1559b?: ,<?% 'ence, it is to be remarked that due to una4ailable data after September 155< is lacking in this study% The time period after mid>September is @uite significant, as the market eCperienced more 4olatility with the default of the $ehman rothers, as also illustrated by the figure 2%, and 2%8% 'ui =1559? find that, at the early stage of the crisis i%e% prior to the $ehman default, for euro, pound, Swiss franc and yen, the funding li@uidity was the maHor concern and main determinant of the changes in the &I) =measured by the $iborJ.IS spread?% It is argued that this is also consistent with the market obser4ation that many non>/S financial institutions turned hea4ily on the FX swap markets to raise dollars for their funding needs when lending in the interbank market became impaired% 'owe4er, eCamining the time period after the default of the $ehman rothers another pattern shows up as eCplanation for the spread in the FX swap implied /S dollar rates i%e% &I) de4iation% 'ui =1559? shows that the funding li@uidity risk still remained a 4ital factor behind the FX swap spread, despite a fall occurred in the eCplanatory power for the euro, pound, Swiss franc and yen% In addition, counterparty risk became a significant eCplanation factor as well, after the $ehman default in the *uropean economies in the &I) de4iations for euro, pound and Swiss franc, which increased the premiums on the swap implied /SD interest rate% 'ui =1559? eCplains that the reduction in the eCplanatory power is partly attributed to the increasing idiosyncratic shocks as a conse@uence of the turmoil in the markets and the eCceptional policy measures introduced by the central banks ='ui =1559?: 9?% 'ui =1559? further eCamines the condition in the (sian currencies, and his empirical work he finds that, funding li@uidity risk was lower in 'ong "ong Dollar, yen and Singapore Dollar compared with that in the /S counterparty risk was not percei4ed as a concern in the money and FX swap markets of these economies ='ui et al =1559?: 1?% / 2 , 2 Transaction 'osts ( number of studies ha4e analysed the de4iation from the &I) in terms of transactions costs% ranson =,989? analysed the persisting de4iations from the &I) in terms of transactions costs% It is stressed the eCistence of some minimum amount before mo4ements of arbitrage funds to eCcites% I%e% brokerBs fee, which reduces the net yield of the transaction% ranson =,989? estimates the minimum differential for both /%S%>/%"% arbitrage and /%S%>&anadian arbitrage to be 5%,< per cent
Side 65 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management per annum% This implies that an arbitrage transaction must gi4e at least 5%,< percent before arbitragers, mainly -ew 6ork banks are willing to mo4e funds between the dollar and the pound sterling or between the dollar and the &anadian dollar = ranson =,989?: ,532?% It is to be noticed that "eynes =,912? suggested it to be 5%05 percent, and *inFig =,98,? suggested 5%58 percent ="eynes =,912?: ,39?L *inFig =,98,?: 05?% .ther studies such as Frenkel and $e4ich =,9:0? measure de4iations from &I) for the /%S%>/%"% eCchange rate, where they estimate the transactions costs for arbitrage to be 5%,20E>>5%,0E per annum, which is slightly lower than the estimate by ranson =,989? and *inFig =,98,? =Frenkel and $e4ich =,9:0?: 318, 33,?% alke and Aohar =,99<? in4estigates /%S%>/%"% data from ,9:2 until September ,993, and find that the a4erage departures from the parity conditions was 5%5< per cent, again close to the pre4ious studies eCcept for "eynes =,912? = alke and Aohar =,99<?: 028?% 'ence, according to (tkins =,99,? and &linton =,9<<?, the empirical studies ha4e demonstrated that transactions costs are much smaller than pre4iously assumed =(tkins =,99,?: 310?% &linton =,9<<? estimates that in the *uromarket transaction costs between &anada and the /S is low as 5%58 per cent on an annual basis =&linton =,9<<?: 380?% 'ence, (tkins =,99,? argues that one would eCpect the *uromarket to ha4e lower transactions costs as the same banks could pro4ide deposits in both currencies, and therefore, it is assessed that a re>e4aluation of the siFe is necessary% Studies conducted by Frenkel and $e4ich =,9<,? estimate a de4iation from &I) o4er the period ,9:3>:9 to be 5%1, per cent, whereas $ongworth =,9<3? estimates it to be 5%12 per cent using /S *urodollar rates and &anadian chartered bank deposit rates% Ahereas Guhl et al =1552? find significant e4idence that due to slower information and communication technology during ,985s>and e4en ,9<5s, led higher transactions costs =Guhl et al =1552?: 305>0,?L =Taylor =,9<:?: 235>3,?% 'ence, as mentioned in chapter 1, the theoretical framework of &I) assumes that assets denominated in domestic and foreign currencies are freely traded internationally, and ha4e negligible transaction costs and similar risks% In particular, transaction costs and political risk (libar =,9:3? are largely negligible in the todayBs K,5 currency markets = aba and )acker =1559a?: 0?L Taylor =,9<9?: 3<8?: 'ui =1559?: 8?% 'ence, according to Taylor =,9<9?, during the floating of the sterling in ,9:1 and the inception of the *uropean Monetary System in ,9:9, significant departures occurred from &I) for periods long enough to @uestion the theory =Taylor =,9<9?: 3:9>3<5, 3<2> <0?% Moreo4er, so far no recent studies ha4e been conducted with the recent turmoil% Therefore, in
Side 66 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management order to make a persistent conclusion whether transaction costs play an important role in the de4iation from the recent turmoil in the FX swap market, more studies needs to be conducted% / 2 , , 2ata im"erfections< eside the abo4e mentioned studies, other authors ha4e criticised the pre4ious conducted empirical work for using time a4eraged data as opposed to point in time data% Taylor =,9<:, ,9<9? employs Yhigh @uality, high fre@uencyD and contemporaneously sampled data for spot and forward /S>>/" and /">> Kerman and euro>deposit interest rates% Taylor =,9<:, ,9<9? finds that 4ery few profitable arbitrage opportunities during periods of turbulence, whereas during relati4ely calm, control period, he finds no e4idence at all of uneCploited profit opportunities =Taylor =,9<:?: 230?L =,9<9?: 3<9?% (gmon and ronfeld =,9:0? do also suggest that the reported de4iation from co4ered interest parity is almost certainly due to the data imperfections rather than any other reason =(gmon and ronfeld =,9:0?: 1:5, 1::?% aba et al% =155<? also highlights that measurement error could ha4e been eCplanation behind the spread between the FX swap implied dollar rate and dollar $ibor% It is stated that during the recent turmoil, dollar $ibor may ha4e underestimated the dollar funding costs that *uropean institutions actually faced = aba et al% =155<?: ::?% Kyntelberg and Aooldridge =155<? stress that the institutions contributing to the $ibor sur4ey, may lead, in certain circumstances, to biased @uotes on the part of institutions that wary of re4ealing information that might increase their borrowing costs in times of stress% It is stated that this factor alone could ha4e created a spread between the FX swap implied dollar rate and dollar $ibor =Kyntelberg and Aooldridge =155<?: 80?% 'owe4er, this field needs further empirical studies, in order to determine the effect of it in the recent turmoil% / 2 , G .ecovery Time alke and Aohar =,99<? stress the significance of de4iations from &I) is the speed with which short>run de4iation from &I) are eliminated and con4ergence to e@uilibrium is achie4ed% It is further argued that, most of the empirical studies eCamine the 4alidity of &I), primarily with the siFe of de4iations relati4e to estimates of transactions costs and pay less attention to the speed with which these profitable trading opportunities are eliminated = alke and Aohar =,99<?: 038?% Many studies ha4e shown that, rele4ant markets are highly efficient in eliminating uneCploited profit opportunities =Frenkel 7 $e4ich =,9:0?: 318?, =Gohn et al% =,9:9?: ,53?% &linton =,99<? assess through informal analysis that, at least for the *uro>market, profitable trading opportunities are small and transitory =&linton =,99<?: 30<>09?% ( similar result has been presented by (tkins =,99,,
Side 62 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management ,993? suggests that de4iations from &I) in the *uro>market are in general eliminated within two days with this time decreasing as one mo4es from the ,9:5s through the ,9<5s =(tkins =,99,?: ,<:L =,993?: 33,?% In contrast, )ippenger =,9:<? presents results that it can take up to se4eral weeks for &anada and the /%S =)ippenger =,9:<?: ,<9>9,?% aba and )acker =1559a? highlights that most studies show that de4iations from the short term &I) condition has decreased significantly, at least among K,5 currencies = aba and )acker =1559a: 0?% Ahereas, (kram et al =1558? pro4ides e4idence that short li4ed arbitrage opportunities arise in the maHor FX markets =(kram et al =1558?: 12?% aba =1559? also emphasise that under the turmoil there has been eCistence of short term de4iation of &I) in the FX swap market = aba =1559?% (s shown in section X, the FX swap spread has remained widened for some time, at least longer than few weeks%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

)/A*T+0 6: A,A7?SIS A,- -IS)#SSI1, 1F T/+ )+,T0A7 BA,9S I,T+0@+,TI1,S 6;either the recent massive money injections, the coordinated lowering of interest rates nor the use of "ublic funds to reca"italiAe banks have done much to restart interbank lending This action did not solve the underlying "roblem "reventing interbank lending< extreme information asymmetry= =Financial Times =155<>9 -o4%?% The abo4e @uotation depicts the se4erity of the turmoil as a range of measures ha4e not sol4ed the eCisting problems in the interbank markets% This section aims to eCplore the maHor 4arious measurements taken into account by the greatest central banks, and analyse the effect of the employed measurements in weathering the recent financial crisis% #.1 ,$erall Central -an( Measures

IS =155<>-o%3,? stress that central banks responded to the strain in the international interbank markets by adHusting their operations in a range of manners :0 to ease the li@uidity demand of the banks =Danmarks -ational ank =155<>,%W?L 3<?% The sustained period of uncertainty in money market conditions led a range of central banks to response to with an array of measures, in order to calm short term interest rate 4olatility and, to address 4arious types of funding market pressures = IS>-o%3, =155<?: ,?% In particular, there is no widely accepted theoretical analysis of how they operate% This lack of a theoretical framework meant that when banks stopped trading with each other soon after the crisis that initiated in (ugust 155:, central banks were unsure accurately how to react =Franklin et al =155<?: ,?L =FreCias et al% =1559?: 2?% Therefore, the obHecti4e of this section is to outline a framework assessing the actions by the central banks% These days, central banks generally conduct money policy through targets on 4ery short term interest rate% The approach comprises two key elements i%e% signaling the desired policy stance through the announcement of a key interest rate =the policy rate? and li@uidity management operations, which co4er 4arious aspects of the operating framework :8, which supports the desired stance by keeping the rele4ant market rate consistent with the policy rate% In general, li@uidity management operations are designed and implemented cautiously to ensure that they influence only the specific market rate targeted by policy% Thus, they play a supporti4e role, neither impinging upon nor containing any information related to the stance of policy% $i@uidity management operations can also be used purposely to influence specific elements of the monetary transmission
75

See (ppendiC <, for the chronology of selected & inter4entions% These include the maturity, pricing and collateral re@uirements for central bank li@uidity = IS =1559abc?: 92?%

:8

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management mechanism, e%g% &ertain asset prices, yields and funding conditions o4er and abo4e the impact of the policy rate% The latter element is @uite 4ital as funding conditions were worsening in the market% In this situation, the li@uidity operations would play a more acti4e role and become an essential part of the o4erall monetary policy stance% .perations in this range usually result in substantial changes in the balance sheet of the central banks, in terms of siFe, composition and risk profile% IS =1559abc? referred to this time of acti4ities to balance sheet policy% *ach operation that has an impact on the balance sheet, the effect will be demonstrated on the balance sheet of the central banks% The 4arious forms of balance sheet policy:: can be distinguished by the specific market that is targeted% 6et, the balance sheet policy employed in this recent crisis has targeted term money market rates and risk spreads% This is definite as illustrated in chapter 2 with high term rates, and credit and li@uidity spreads% IS =1559abc? argue that in principle, the effects of balance sheet policy may be con4eyed through two focal channels% The first is the signaling effect i%e% operations performed by central banks or communication, influence public eCpectations about chief factors that support the market 4aluation of the assets, which is assessed @uite powerful% These factors comprise eCpectations regarding the future course of policy, inflation, relati4e shortage of different assets or their risk and li@uidity profiles:<% The second channel works through the impact of central bank operations on the composition of pri4ate sector portfolios% Ki4en assets that are imperfect substitutes for one another, changes in relati4e asset supplies through central bank operations greatly change the composition of portfolios% In order to compensate, relati4e asset yields usually need to change, and such changes may consecuti4ely influence the real economy% To the degree that this process leads to stronger balance sheets, heightened collateral 4alues and higher net worth, it may assist to release credit constraints, lower eCternal finance premia, and hence refresh pri4ate sector intermediation:9% Therefore, this section aims to outline the framework for re4iewing the 4arious aspects of the responses of the central banks% Therefore, the following section intends to gi4e an o4er4iew of the central bank responses to strains in interbank markets% (s sol4ing the strains in the interbank market would conse@uently ha4e an impact on the FX swap market strains%

::

FX inter4ention is the most regular form% In here, purchases or sales of foreign currency intend to impact the le4el of the eCchange rate separately from the policy rate that defines the official policy stance = IS =1559abc?: 90?% 78 For instance, the announcement of engagement in operations in4ol4ed illi@uid assets may in itself impro4e in4estor confidence in those assets, in that way reduce li@uidity premia and stimulating trading acti4ity%
:9

(n eCample of this is when risky pri4ate securities are purchased from banks in eCchange for risk>free claims on the public sector, the resulting impro4ement in the o4erall risk profile of bank balance sheets may augment both the willingness and the ability of banks to lend%

Side 2% af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management #.2 ,$er$ie+ of Central -an( Measures

The central banks responses can be di4ided into three board types according to how the associated operations are related to their near obHecti4es, figure 8%,<5% The first category response implies measures to ensure that the market rate is near policy rates =or target rates? through more acti4e reser4e<,management, accordingly assuring banks of their orderly access to o4ernight funds% The second category consist initiati4es to alle4iate strains in general interbank markets i%e% term markets and repo market by increasing the a4erage maturity of refinancing pro4ided to banks, eCpanding, where needed, the range of eligible collateral and counterparties, and increase the scope of securities lending etc% The last two categories, insofar as they in4ol4e operations directed at particular segments of the transmission mechanism o4er and abo4e the traditional interest rate target, fall under the umbrella of balance sheet policy = IS =1559abc?: 9:?%

80

See (ppendiC 9, for the third category% (s the third category consist of responses intended at supporting specific credit markets, in particular the non>bank segments, and easing financial conditions more broadly, which is out of the scope of this paper, hence this last part of inter4entions do ha4e a significant link to the following go4ernment inter4entions that had an o4erall impact on boosting the confidence between banks, and therefore percei4ed as an important aspect%
<,

For instance, the three central banks, Fed, *& and o*, impose an a4erage reser4e re@uirement on banks% This contains that the banks must maintain a certain a4erage minimum deposit at the & for a reser4e maintenance period of about one month in the *& and o* and of two weeks in the Fed% The purpose of imposing reser4e re@uirements is to stabilise the o4ernight interest rate% This pro4ides the banks an incenti4e to lend li@uidity in the money market when the o4ernight interest rate is high compared to the interest rate on the deposits in reser4e re@uirement accounts% (lternati4ely, the banks ha4e the incenti4e to maintain sufficient reser4es in periods when the o4ernight interest is low% &oncerning the o*, the banks ha4e the option to determine, within certain limits, the siFe of their reser4e re@uirements and change them from month to month =Danmarks -ationalbank =155<>,%W?: 39>25?%

Side 2' af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
3igure C +0 'entral #ank .es"onses to the 'risis

1bCective
Achieve the 1""icial Stance o" Monetar *olic

Adopted Measures
*Cceptional fine>tuning operations &hange in reser4e re@uirements -arrower corridor on o4ernight rate )ayment of interest on reser4es Increased treasury deposit Short>term deposit or central bank bill Modification of discount window facility *Cceptional long>term operations roadening of eligible collateral roadening of counterparties Inter>central bank FX swap lines Introduction to increasing of conditions for securities lending

Fe d X X3 X X X0 X X X X X

+) B C, X X X8 X C

Bo + C C1 C C C C C C C C

Bo 4 C C2

Bo ) X

0, B C

S, B C

X C C C C C C X X X X X C C C X C C X X X

Interbank Market )onditions

$ource< &#!$ &2009-79th)< 97K #!$ &200>-;o ,+)< C) -otes: Fed T Federal +eser4eL *& T *uropean &entral ankL o* T ank of *nglandL oG T ank of GapanL o& T ank of &anadaL + ( T +eser4e ank of (ustraliaL S- T Swiss -ational ank% Z T yesL blank space T no% ,? Including front>loading of reser4es in maintenance period% 1? *Cpand range o4er which reser4es are remunerated% 3? $ower the discount rate relati4e to the target federal funds rate% 2? )ay interest on eCcess reser4e balances =&omplementary Deposit Facility?% 0? +educe rate and eCpand term on discount facilityL allow participation of primary dealers =)rimary Dealer &redit Facility?% 8 Including fiCed rate full>allotment operations%

6:$:' Achievin! the 1""icial Stance o" Monetar *olic The operational target for central banks is to ensure that the o4ernight money market interest rate reflects the official interest rate =Danmarks -ationalbank =155<>,?: 19?% (t the onset of the crisis, there was obser4ed a strong increase in demand for central bank li@uidity i%e% central bank reser4es, hence as the crisis unfolded, commercial banks desired increased li@uidity beyond central bank s was capable of =IMF =155<?: 99?% Thus, central banks mainly intended at defy the unstable demand for central bank reser4es and this keeping money market rates in line with policy targets% In particular, + (, o&, *&
<1

oG, S- , the Federal +eser4e and, from September, the

o*

conducted market operations<3 that were either outside their regular schedule i%e% fine tuning or in large than usual amounts<2 =Danmarks -ationalbank =155<>,?: 28?L IS>-o%3, =155<?: 13?<0%
<1

In general, the *urosystem has disposal a set of monetary policy instruments a4ailable to achie4e its obHecti4es% The *urosystem conducts open market operations, offers standing facilities and re@uires credit institutions to hold minimum reser4es on accounts with the *urosystem% The main obHecti4e of the *urosystem is to maintain price stability, as defined in (rticle ,50 of the Treaty =*& =155<t?: :?% See (ppendiC ,5, for these policy instruments, and the se4eral Fed programs that ha4e been implemented% 83 In the period from 9 (ugust and the following neCt fi4e days, S- , *& , oG, Fed conducted o4ernight fine tuning operation for &'F ,%2 bn, */+ 1,1 bn, G)6 , trillion, /SD 3< bn respecti4ely% The supply of Fed, ,5 (ugust 155: has been the largest 4olume since September 155,% It is noteworthy that o* did not increase the li@uidity supply until the reser4e maintenance period started in September when banks chose to raise their reser4e targets% =Danmarks -ationalbank =155<>,?: 28?L = IS>-o%3, =155<?: 13? 84 IS =155<> -o%3,? state that o4erall, central banks did not inHect more reser4es than needed in order to maintain market rates near policy targets = IS>-o%3, =155<?: 8?%
<0

.ther means such a public announcements, assuring market participants of the accessibility of o4ernight standing lending facilities and accommodating a higher le4el of reser4es holding, were also applied to help contain o4ernight rate 4olatility and to balance the supply of and demand for central bank reser4es at the policy rate% See appendiC X, for further detailed information for the step by step actions taken by 4arious central banks

Side 2$ af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

(fter an intermeeting statement on ,: (ugust 155: that downside risks to growth had increased substantially, the Federal .pen Market &ommittee =F.M&? <8 cut the federal funds target rate by 05 basis points to 2>3J2 percent at its meeting in ,< September 155: =Federal +eser4e System =155:mn?: ,?% (s shown in figure 8%1, o4er the following se4en month i%e% from .ctober 155: to (pril 155<, the F.M& lowered its target rate by additional 1:0 basis points and became two per cent 35 (pril 155< =Federal +eser4e System =155:mo, mp?L 155<m@, mr, ms?% *4en though it was widely eCpected to tighten policy at the meeting in September 155:, in order to inflationary pressures, the 8 September 155: the *& Ko4erning &ouncil announced that it left the interest rates on the marginal lending facility and the deposit facility <: will remain unchanged at 2%55E, 0%55E and 3%55E respecti4ely, as well as in subse@uent months, referring to high le4el of uncertainty in the financial outlook =*& =155:>)+a?: ,?% Similarly, the oG remained the uncollateralised o4ernight call rate around 5%0% per cent, and continued to monitor mo4ements in the international financial markets as well as the global economic de4elopments behind them = oG =155:>)+b?: ,?L IS =155<>-o%3,?: ,5?%
Figure 8%1 (olicy .ates+, in "er cent

The o* remained the policy rate unchanged in September 155:, citing a recent easing in inflation and the call for monitor the e4olution of both the price and @uantity of credit, and reduced its policy rate by [ percentage point between December and (pril% The o& also remained the policy rate i%e%
$ource< &#!$ &2009-70th)< 9+, 9,) -ote: ,? For the Federal federal funds for the *& , interest on the main refinancing operationsL for the the operating band +eser4e, for thetarget o4ernight raterateL and bank rate at 2 rate [ percent in September 155:, despite oG, target for the uncollateralised o4ernight call rateL for the o*, ank rate% For the + (, target cash rateL for the o&, target o4ernight rateL for S4eriges repo rateL the Swiss ank, midpoint of the three>month $ibor target range% prior eCpectations of +iksbank, tightening, andfor began to -ational ease policy in 0 December 155: << = o& =155:>)+c,

)+d?: ,?% The S- raised its target band for the three month Swiss franc $ibor to 1%10>3%10 per cent

= IS>-o%3, =155<?: 8?%

<8 <:

The federal funds rate is the market>determined interest rate on o4ernight interbank loans =&hecchetti =155<?: :?%

The *urosystem offers credit institutions two standing facilities: ,? -arginal lending facility in order to obtain o4ernight li@uidity from the central bank, against the presentation of sufficient eligible assetsL and 1? 2e"osit facility in order to make o4ernight deposits with the central bank% =*& =1559??% 88 o& announced that it lowered its target for the o4ernight rate by one>@uarter of one percentage point to 2 \ per cent% &orrespondingly, the operating band for the o4ernight rate lowered and the bank rate became 2 ] per cent = o& =155:>)+d?%

Side 2( af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management in ,3 December 155:, whereas the policy remained on hold in the December 155: and ,3 March 155< meetings<9 =S- =155:>)+cc?: ,?L S- =155<>)+cc, )+cd?: ,?% Ahen eCamining other economies, the financial market turmoil had a less affect in the outlook sufficiently to affirm an easier monetary policy stance% (s shown in the figure 8%1, for instance, the + ( continued to increase its target cash rate se4eral times between (ugust 155: and early 155<% < (ugust 155:, the oard decided to increase the cash rate by 10 basis points to 8%0 per cent, while in : -o4ember 155:, it increased 10 basis points again to 8%:0 per cent% This was repeated again 0 February where the rate increased by 10 basis points to :%5 per cent =+ ( =155:>)+cc?: ,?L + ( =155:>)+cd?: ,?L + ( =155<>)+cc?: ,?% (s well as +iksbank which continued on its pre4ious policy path i%e% raising its repo rate in late 155:, for instance, 35 .ctober 155:, the board decided to increase the repo rate by 5%10 percentage points to 2 per cent, and 1 February 155<, the repo rate increased once again by 5%10 basis points to 2%10 per cent =+iksbank =155:>)+a, )+b?: ,?% 'owe4er, as shown in figure 8%3, some central banks had substantially difficulties in maintaining the o4ernight interest rates close to their targets, with the start of the turmoil% In the /S, 4ital inHection of reser4es to resist firming of rates early in the day on occasion resulted in marked softness in rates close to the business and on subse@uent days in the same maintenance period% In contract, in (ugust 155:, the o* did not eCpand reser4e supply, o4ernight rates became rather ele4ated95% = IS>-o%3, =155<? highlights a 4ital obser4ation, as although numerous central banks had standing lending facilities to ser4e as a li@uidity backstop, these facilities, in some situations only limited protection against upward pressure on money market rates% *specially, in the /S due to stigma, there was limited use of the standing lending facility =discount window?, e4en during periods in which interbank rates increased abo4e the lending facility rate% This is shown by the left panel in figure 8%3%
Figure 8%,, !ndication of $tigma

<9

(dditionally, as a respond to the upward pressure on the three>month Swiss franc $ibor, the S- lowered its repo auction rate in order to bring the $ibor down to le4els in line with the target bandBs midpoint% ,3 September 155:, the repo rate was lowered =The three>month $ibor for Swiss francs, increased as high as 1%9 per cent?, and came as a surprise to market participants% It had a substantial impact on the $ibor and therefore on the effecti4e stance of Swiss monetary policy =S- =155:>)+cd?: 1>3?L IS =155<>-o%3,?: ,5?%
95

Ki4en the 4olatile conditions at the time, the fluctuations of market interest rates around the policy rate targets of the central banks, in all maHor currency areas increased to 4arying degrees in the first weeks of the turmoil% 'ence, o4er the following weeks, central banks were better to achie4e control of the targeted market rates, by adHusting their operations = IS =155<>-o%3,?: ,,?%

Side 2. af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

$ource< #!$ &200>-;o ,+)< +2) -ote: ,? In billions of local currency unitsL daily data for the *& and the ank of *ngland, weekly a4erages of daily amounts outstanding for the Federal +eser4e% 1? In per cent% 3? For the Federal +eser4e, primary creditL for the *& , marginal lending facilityL for the ank of *ngland, lending facility%

It is further stated that stigma is in part of legacy of the days when discount window credit was pro4ided at a subsidies rate and in4ol4ed allowance and search% )ossibly, stigma may eCist due to borrowing at a "enalty rate sends an ad4erse signal about creditworthiness that increase reluctance of banks to use the facility% (s the figure illustrates, in contract to the /S market, when eCamining the euro area stigma appears to be less of an issue% During the turmoil, there were no reported interbank trades at rates abo4e the marginal lending facility =M$F? rate, and it has been obser4ed that the facility was used as fre@uently as in more tran@uil periods =&ecchetti =155<?: 8?% 'ence, = IS>-o%3, =155<? stresses that the perception of M$Fs could be changed, in particular intense conditions% *Camining the situation in /", there were 4ery few days in which the daily high in interbank rate reported by brokers eCceeded the standing facility rate% 'owe4er, anecdotal reports suggest that higher rates had been paid in bilateral deals and that stigma inhibited borrowing from the standing facility, especially after the pro4ision of emergency li@uidity assistance 9, to -orthern +ock, a mid>siFed /" bank in ,2 September 155: = o* =155<>(nneC?: 03?L IS>-o%3, =155<?: ,,?% .4erall, although the reluctance on the part of counterparties to use standing facilities may in certain cases ha4e complicated central banks efforts to keep 4ery short term market interest rates under control% &entral banks were @uite able to achie4e their operational obHecti4e of returning market interest rates close to their policy rate targets% In general, interest rate 4olatility decreased
9,

(ccording to paragraph ,2 of the Memorandum of /nderstanding between 'M Treasury, the ank of *ngland and the Financial Ser4ices (uthority states: L!n exce"tional circumstances, there may be a need for an o"eration which goes beyond the #ankMs "ublished framework for o"erations in the money market $uch a su""ort o"eration is ex"ected to ha""en very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance in the F* economy L =Tucker =1559?: ,2?%

Side 25 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management after the first month% -e4ertheless, the stability of 4ery short term rates remained 4ulnerable and central banks had to apply a more acti4e attitude, in order to contain further occurrence of 4olatility, which is further elaborated on in the sections below = IS>-o%3, =155<?: ,,?% ?fter 1ehman 2efault (fter the default of $ehman

rothers, intense pressure was obser4ed in the markers by weeks, as

also shown in chapter 2, $ibor>.IS spreads increased dramatically, which appeared as a threat to the stability of key financial institutions, and the o4erall economic acti4ity = IS =1559abc?: 93?% .n < .ctober 155<, central banks simultaneously announced cuts in their policy rates% The siC maHor central banks agree to conduct the first round of coordinated rate action% .ther central banks around the world also showed a similar trend, where rates where cut rapidly% The Federal .pen Market &ommittee has decided to lower its target for the federal funds rate 05 basis points to ,>,J1 percent =Federal +eser4e System =155<lol?: ,?% (t the same time, *& announced to reduce the interest rate on the marginal lending facility by 05 basis points to 2%:2 per cent and to reduce the deposit facility by 05 basis points to 1%:0 per cent =*& =155<>)+lol?: ,?% o* also reduced the bank rate by 05 basis points to 2%0 per cent = o* =155<>)+lol?: ,?% eCpressed its strong support of the of the policy actions conducted by the other central banks =155<>)+lol?: ,?% The SoG oG

decided to ease conditions by 05 basis points in a bid to decrease the

Swiss franc three>month $ibor from 3 per cent to 1%0 per cent% Furthermore, the target range was reduced to 1>3 per cent =S- =155<>)+lol?: 1?% +iksbank decided to cut the repo rate by 05 basis points to 2%10 per cent as part of the Hoint announcement =+iksbank =155<>)+lol?: ,?% The o& also announced to lower its target for the o4ernight rate by ,%0 per cent point to 1%0 per cent, and the operating bank for the o4ernight rate was lowered correspondingly, and the cent = o& =155<>)+lol?: ,?% y the end of May 1559, the Federal +eser4e, the oG, the o*, the o&, S4eriges +iksbank and the S- had brought policy rates close to Fero% The *uropean &entral ank lowered its main policy rate by 3\ percentage points between September 155< and May 1559, but stopped well before it reached the Fero lower bound% The sufficient supply of central bank balances from late 155< and onwards pressed o4ernight rats close to the rate on the *& s deposit facility, and almost to Fero% &entral banks stopped easing once policy rates reached le4els slightly abo4e Fero, as usually bank deposit rates are below money market rates, the former may reach Fero e4en if the latter are still ank rate to 1 [ per

Side 26 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management positi4e% anks needs to maintain a margin between deposit and lending rates to remain profitable

= IS =1559>:9th?: 93?91% ;arrower corridor on overnight rate In order to keep the short term rates to the policy target, the *& , o* and the Federal +eser4e reduced the width of the effecti4e corridor on o4ernight rate by changing the rates applied on end of>day standing facilities% For instance, ,0 December 155<, the Federal +eser4e announced a :0 basis point decrease in the discount rate93 to ] per cent, and earlier the day, the F.M& decided to lower the target for the federal funds rate from , percent by establishing a target range of Fero to \ per cent =Fed =155<>)+lok?: 3?92% Furthermore, as of 9 .ctober 155<, the *& main refinancing operation =*& reduced the corridor90 of standing facilities98 from 155 basis points to ,55 basis points on the interest rate on the =1559>M >(ug?: ,,2?% Simultaneously, central banks eCpanded their capacity to reabsorb eCcess reser4es to neutralise the impact on o4ernight interest rates of the much eCpanded operations% This has been implemented in a number of ways, reflected in the composition of central bank liabilities in figure I;29:, where an increase in the liabilities in particular after 155<% The o* and the S- initiated to issue central bank bills, whereas the *& and the + ( preferred highly to rely on accepting interest bearing deposits% The Federal +eser4e, accepted greater amount of deposits from the Treasury, and began to pay interest on reser4es, which is usually not the case =&ecchetti =155<?: :?% In o4erall, although central banks had substantial accomplishment in keeping 4ery short term interest rates in line with their policy rate targets, it was rather more difficult to assess the defined effect of central bank inter4entions in addressing funding market pressures% ( 4ery important obser4ation has been that central bank inter4entions ha4e not been able to eliminate the tensions and did not manage to pre4ent tensions from returning subse@uently, at least in the early stages of
91

IS =1559abc? states that financial market tensions and the increase in credit and li@uidity risk premia impaired the program mechanism% For instance, yields on corporate bonds increased despite sharp declines in policy rates% Kenerally, banks passed reductions in their funding costs on to their customers, but tightened credit standards 4itally, offsetting the impact of cuts in the policy rate on o4erall financial conditions = IS =1559abc?: 92?% 93 anks can usually borrow from the Fed at what it is called the (rimary 1ending .ate, also commonly called the discount rate =cecchetti =155<?: :?% 94 Since Ganuary 1553 there has been a change in the procedure, the primary lending rate has been set at a premium abo4e the target federal funds rates% efore to the start of the crisis in 155:, the premium was one percentage point, or ,55 basis points% (s the bank can be @ualified and is willing to pay the penalty interest rate, it can get the loan =cecchetti =155<?: :?% 95 The interest rates on the marginal lending and deposit facilities normally pro4ide a ceiling and a floor for the o4ernight market interest rate =*& =1559?%
98 9:

The Ko4erning &ouncil of the *& , also decided that as of 1, Ganuary 1559, to re>widen the corridor of standing facility rates, symmetrically to 155 basis points =*& =1559>M >(ug?: 153?% See (ppendiC 9, for figure 9%3, 'entral #ank ?ssets and 1iabilities, in billions of res"ective currency units

Side 22 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management the crisis% (ccording to IS =155<>-o%3,? this relies in the underlying reasons of term money

market tensions% (s tensions were caused by li@uidity issues, in principle this would be addressable by central bank inter4entions, in order to impro4e the supply and distribution of li@uidity% 'ence, if the underlying reasons were dri4en by counterparty credit risk concerns the central bank li@uidity operations would ha4e been unable to weather the problem, which ha4e been the case, in the early stages of the crisis at least% 6:$:$ In"luence 8holesale Interbank Market )onditions These measures applied is @uite prominent during the initial stage of the crisis, as they focused on reducing term interbank market spreads, which was fairly high as shown in chapter 2 % In order to impro4e the continued pressure in term money markets, central banks took two main approaches i%e% referred to as the indirect and direct methods% C 2 2 + !ndirect ?""roach The indirect approach aimed to reassure financial institutions of the sufficient supply of o4ernight funding% This approach aimed to increase the institutions willingness to eCtent term loans in the market by increasing the confidence in the financial institutions ability to fund themsel4es reliably in the o4ernight market% (long with the abo4e mentioned li@uidity management measures to keep short term market rates stable around policy targets contributed to this effect% The mo4e by the Fed to enhance the attracti4eness of its standing loan facility was also a step in this direction% The spread between its lending rate =the discount rate? and the federal funds rate target was narrowed from ,55 basis points to 05 basis points in mid> (ugust 155:, and then to 10 basis points in mid>March 155<% Moreo4er, the maCimum allowable term on such loans increased from o4ernight to 35 days, and subse@uently to 95 days% C 2 2 2 2irect ?""roach The direct approach intended to increase the pro4ision of term funds through market operations% In (ugust 155:, the *& started to conduct supplementary three month refinancing operations and in 1< March 155< announced two siC month refinancing operations to be conducted in (pril and Guly% 1 (pril 155<, *& conducted the first supplementary siC month to supply */+ 10 billion and, in 9 Guly 155<, conducted a supplementary three month of */+ 05 billion = IS>-o%3, =155<?: 38>3:, 25?% In ,3 September 155:, the Sconducted its first three>month repurchase transaction, and offered other term transactions as needed in the subse@uent months% ( similar trend was obser4ed in the + (, the oG, the Federal +eser4e and the o* as they also eCpanded their pro4ision of term
Side 23 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management funds% The contribution of the *& and S- in supplying term /S dollar funding in coordination with the new Term (uction Facility of the Fed was an inno4ati4e 4ariation on the same theme% -odification of 2iscount 8indow 3acility and Term ?uction 3acility &T?3) In an effort to lower the unusual term lending spreads as shown in chapter 2, the Fed took a range of actions9<, besides lowering the spread between the discount rate and the fed funds target% The discount window99 is a traditional tool of Fed, which assist to relie4e li@uidity strains for indi4idual depository institutions and the banking system as whole, by pro4iding source of funding in time of need% Since 1553, depository institutions ha4e had access to three types of discount window credit i%e% primary, secondary and seasonal credit,55 =Fed =1559>M+?: :?L &ecchetti =155<?: :?% .n ,1 December 155:, the Federal +eser4e announced the introduction of the Term (uction Facility =T(F?,5, which pro4ides one>month loans against discount window collateral to a 4ery wide range of banks, through biweekly auctions, along with the abo4e mentioned coordinated actions by other central banks =Federal +eser4e System =155:$$?: ,?% The T(F program,51 allows eligible financial institutions in sound financial conditions to make bids for term borrowing from the Fed, with maturities typically of 1< days or 30 days, instead of o4ernight =Au =155<?: 0?L Taylor and Ailliams =155<a?: 12?% From late December 155:, two T(F auctions ha4e been held each month% The spread between the T(F rates and the .IS rate at the time bids were taken a4eraged approCimately 05 basis points for the first two auctions, but then decreased in subse@uent auctions, before rising again to around 25 basis points in the first auction of March 155< =Taylor and Ailliams =155<a?: 12>10?%
9<

.ther measures aiming to impro4e the accessibility to market li@uidity in a broader sense were taken into reflection% *%g% in order to promote the orderly market functioning of repo markets, the Federal +eser4e designed two new facilities for primary dealers in the mid>March 155< i%e% the Term Securities $ending Facility =TS$F? The )rimary Dealer &redit Facility =)D&F? =Federal +eser4e System =155:$k?% In the TS$F, primary dealers can borrow /S Treasury securities for up to 1< days against certain agency>guaranteed and other high>@uality pri4ate M S, additionally to collateral eligible for usual .M.s% Ahereas the )D&F offers primary dealers o4ernight discount window loans against certain in4estment grade debt securities as well as collateral for regular .M.s = IS>-o%3, =155<?: :?%?% Au =155<? stress that these two facilities had less effect on the $ibor>.IS spreads% 'ence, this will not be further eCplained as its out of the scope of the paper%
99

The general policies that go4ern discount window lending are set forth in +egulation ( of the oard%

,55

)rimary credit is a4ailable to generally sound depository institutions with few administrati4e re@uirements% Second credit may be pro4ided to depository institutions that do not @ualify for primary credit, subHect to re4iew by the lending +eser4e bank% Seasonal credit pro4ides short term funds to smaller depository institutions that face regular seasonal swings in loans and deposits =Fed =1559>M+?: :?%
,5,

/nder the T(F program, the Federal +eser4e will auction funds to all depository institutions i%e% institutions with reser4able deposits, commercial banks, sa4ing and loans, sa4ings banks and credit unions, as well as to /S branches and agencies of foreign banks, against the wide 4ariety of collateral that can be used to secure loans at the discount window% Most securities and loans on the books of depository institutions include assets denominated in the maHor foreign currencies and many asset booked abroad =Federal +eser4e System =155:$$?: ,?% This program in contract with regular open market operations =.M.s? , which are conducted with the 15 primary securities dealers only and against a narrower set of collateral i%e% Treasury or /S go4ernment agency securities including agency guaranteed Mortgage acked Security =M S? = IS>-o%3, =155<?: :?%
,51

The initial amount set for each auction was N15 billion and was then increased to N35 billion in Ganuary 155< and N05 billion in March 155< =Au =155<?: 0?%

Side 2& af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management In 1, (pril 155<, the o* introduced the Special $i@uidity Scheme, a facility in which banks can swap high>@uality but temporarily illi@uid assets for /" treasury bills% The asset swap can be undertaken at any point within a siC month drawdown period and ha4e terms of one year =renewable to up to three years?% (s only legacy assets eCisted as of end 155: are eligible for the swap, the scheme aimed to impro4e the li@uidity position of the banking system and not to finance new assets = o* =155<ab?L o* =155<ac?L IS>-o%3, =155<?: :?% The Special $i@uidity Scheme designed by the o* was also recei4ed well by market participants = IS>-o%3, =155<?: ,1>,2?% #.3 The .ffecti$eness of the Term Auction )acility /TA)0

+egarding the effecti4eness of the T(F has been @uite different in the literature% (ccording to Au =155<?, the empirical findings suggest that the T(F had strong effects in relie4ing the li@uidity concerns in the interbank market, yet has little effect in lowering the counterparty risk premiums among maHor financial institutions% (s the figure 8%2 illustrates, the one>month $ibor spread o4er the .IS rate fell rapidly from the peak of ,,, basis points in early December 155: to below 35 basis points in late Ganuary 155< =Taylor and Ailliams =155<a?: 18?L Au =155<?: 8?L Mc(ndrews et al% =155<?:,:?%

Side 3% af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
)igure #.12 %ntro uction of TA) Auctions an 1ibor 2,%" "prea s

$ource< &Taylor and 8illiams &200>a)< 2C) -ote: Due to una4ailable data for the rest of the time period i%e% (pril 155< to March 1559, will not be presented%

The 4ertical lines in the figure, depicts the dates of the T(F auctions, along with the one>month and three month maturities% Subse@uent to the first two auctions, the T(F rate has been between 2 and ,8 basis points below the pre4ailing one>month $ibor rate% 6et, Au =155<? stress that T(F, on a4erage, reduced the one>month $ibor >.IS spread by at least 3, basis points, and the three>month $ibor .IS spread by at least 22 basis points =Au =155<?: 1, ,<?% 'ence, the spread widened once again in early March 155< to around 85 basis points and continued to increase <5 basis points in mid (pril =Au =155<?: 8?% Dudley =1559? and Taylor and Ailliams =155<?, it is important to stress that, the effect of the T(F, is not to increase the amount of total li@uidity in the funding markets% (s an increase in li@uidity that comes from banks borrowing from the Fed utilising the T(F would be offset by open market sales of securities by the Fed to keep the total supply of reser4es from falling rapidly% The Fed must sell securities to keep the federal funds rate on target =Taylor and Ailliams =155<a?: 1<?L =Dudley =1559?: 3?% 'owe4er, according to Fed =1559>M+? credit pro4ided to depository institutions through the discount window and T(F has continued, primarily reflecting reductions in loans outstanding under the T(F% It has further been reported that the T(F auctions ha4e been undersubscribed and as a result, the auction rates has been e@ual to the minimum bid rate of 10 basis points for some time% In addition, the (ugust T(F auctions ha4e been reduced in siFe to N,55 billion from N,10 billion in Guly% It has been anticipated by the Federal +eser4e that the siFes of T(F auctions will gradually be reduced if market conditions continues to impro4e =Fed =1559>M+?: :?%
Side 3' af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Eligible collateral (nother 4ery crucial de4elopment that 4arious central banks engaged in was to widened, either temporarily or permanently, the range of eligible collateral and, in some situations counterparties so as to pro4ide an effecti4e distribution of central bank funds% *%g% in (ugust 155:, the o& announced special operations that accepted temporarily as collateral all securities that were already eligible for its standing li@uidity facility =S$F?% In December and early 155<, this was followed by term repo operations that accepted a wider than normal range of collateral ,53 = o& =155:abc?L IS -o%3, =155<?: :?% In mid>(ugust 155:, SIn late September and .ctober 155:, the also announced a similar eCpansion of its eligible collateral list with effect from , .ctober as an indirect response to the turmoil =S- =155:aa?: ,?% o* offered four special three>month tenders against a wider range of collateral and to a wider set of counterparties% In December =155:? as part of the coordinated central bank inter4entions, the o* also announced its widened collateral list and that it increased the siFe of its standard three month repo operations ,52 = IS>-o%3, =155<?: :?L = o* =155:aa?: ,>1?% ( comparable characteristic for all regular discount and T(F loans is that they must be fully collateralised to the satisfaction of the lending +eser4e ank, with an appropriate Mhaircut# applied to the 4alue of the collateral ,50% It is to be emphasised that collateral plays a 4ital role in mitigating the credit risk associated with these eCtensions% The Federal +eser4e generally accepts as collateral for discount window loans and T(F credit any assets that meet regulatory standards for sound asset @uality% The table 8%, below shows the lendable 4alue of securities pledged by depository institutions by rating, as of 19 Guly 1559% (s it can be seen, in particular, ((( securities had been lent out, at a 4alue of N150 billion, followed by secured securities such as /S Treasury etc, and other in4estment grade, which is based on credit re4iew by the +eser4e ank% This also shows the need for securities with high credit rating, in order to ensure no default in payments%

,53

For instance, the + ( also widened the list of collateral eligible for its regular repo operations from September 155:, and its o4ernight repo facility to include a more broad range of bank paper as well as +M S and ( &) =+ ( =155:a??% 104 The widened collateral list also includes (((>rated +M S and co4ered mortgage bonds = o* =155:aa?: ,>1?% See (ppendiC ,,, for the full list of collateral for o* and for *& see https:JJmfi>assets%ecb%intJdlaZ*(%htm% 105 In eCtending credit to depository institutions, the Fed closely monitors the financial conditions of borrowers, by employing the internal rating system, which pro4ides the framework for identifying entities that may pose undue risks to the Fed% -ote: The monitoring of the financial condition is a four step process, designed to minimize the ris of loss to the !ed" The first step is monitoring the ongoing #asis, the safet$ and soundness of all depositor$ institutions that access or ma$ access the discount %indo% and other ser&ices pro&ided #$ the !ed" The second step is identif$ing institutions %hose condition, characteristics, or affiliation %ould match higher than accepta#le ris to the !ed in the a#sence of controls on their access to !ed lending facilities" The third step is communicating rele&ant information regarding those institutions identifies as posing higher ris " The fourth step is implementing appropriate measures to mitigate the ris s '!ed '2009()*+, 7(8+

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

Table #31 1en able 4alue of "ecurities Ple ge by Depository %nstitutions by 'ating5 As of 26 7uly5 2886

T pe o" Securities /%S% Treasury, agency, and agency>guaranteed securities , and .ther securities ((( (aJ((, (1 3 aaJ .ther in4estment grade2 Total

7endable @alue <D billions= ,39 150 28 88 3, ,52 09,

$ource< &3ed &2009--.)< 9) -ote: $endable 4alue is 4alue after application of appropriate haircuts% ,? Includes short>term securities =STSs? with (>,P rating or MIK , or S)>,P municipal bond rating% 1?% Includes STSs with (>, rating or S)>, municipal bond rating% 3?% Includes STSs with (> 1, )>1, (>3, or )>3 rating% 2?% Determined based on credit re4iew by +eser4e ank%

Fed =1559>M+? stress that the category of assets includes most performing loans and most in4estment grade securities, including &M S, &D., &$., and certain non>dollar denominated foreign securities, only ((( rated securities are accepted% 'ence, institutions may not pledge as collateral any instruments they ha4e issued% (dditional collateral is re@uired for discount window and T(F loans with remaining maturity of more than 1< days> for these types of loans, borrowing solely up to :0 per cent of a4ailable collateral is permitted =Fed =1559>M+?: 9?% IS>-o%3, =155<? argues that it was difficult to disentangle the effects of the 4arious reasons for the central banks in the beginning of the turmoil% (s the purpose of the central bank inter4entions was to address the term money market tensions, IS>-o%3, =155<? @uestions whether central banks had completely satisfied the rele4ant demand% *specially, the central bank offers term funds were in many cases keenly taken up resulted in ele4ated auction stop out rates, suggests that the operations only ha4e met the underlying funding needs partly% Despite matters regarding the 4olume of term fund pro4iding operations, there was e4idence, in particular subHect to the array of eligible collateral assisted alle4iate the fallout from the common illi@uidity in credit markets% In gi4en situations, pri4ate sector counterparties were in some e4ents keen to finance their less li@uid collateral with the central bank = IS>-o%3, =155<?: ,3?% $wa" 1ines (nother 4ery significant was the establishment of inter central bank swap lines to alle4iate mostly dollar funding pressures, which was the reason to the spill o4er to the FX swap market% This was a Hoint establishment by notably central banks i%e% The Federal +eser4e, the *uropean &entral ank, the Swiss -ational ank% (s the /S dollar shortages of *uropean financial institutions did not show any signs of impro4ements, in December 155:, the Fed, the *& and the S- > for the first time in
Side 3( af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management its history, responded in a coordinated manner to address the /S dollar shortage these financial institutions were facing = aba 7 )acker =1559>-o%1<0?: 0?L S- =1559?: 15?% In order to impro4e the functioning of the year> end concerns in the financial market by pro4iding li@uidity, the Federal .pen Market &ommittee =F.M&?,58 announced the establishment of temporary swap lines, or Mreciprocal currency arrangements#, with the *& , the S- , the o* and the oG in ,1 December 155:,5:, which aims to pro4ide li@uidity in /S dollars to o4erseas markets =SF+ -6? =155<?: 1?L *& =155<?: ,1, <1?% These swaps in4ol4e two transactions i%e% when a foreign central bank draws on its swap line with the Fed, the foreign central bank sells a particular amount of its currency to the Fed in eCchange for dollars at the pre4ailing market eCchange rate% (t the same time, the Fed ,5< and the foreign central bank enter into a binding agreement for a second transaction that obligates the foreign central bank to buy back its currency on a specified future data at the same eCchange rate% The second transactions undo the first, and at the end of the second transactions, the foreign central bank pay interest, at a market>based rate, to the Fed =Federalreser4e%go4 =1559??% (s of 3, December 155<, total dollar li@uidity to foreign central banks was N002 billion, hence as of 19 Guly 1559 this dropped to N<< billion =Fed =1559>M+?: 0?% (ccording to McKuire and )eter =1559?, the @uantities of /S dollar distributed, illustrated by the figure below, may pro4ide an indication of the /S dollar funding shortfall of *uropean banksB% (s figure 8%0, shows the /S dollar lending in the *urosystem and the Swiss -ational bank froFe in the first @uarter of 155<% 'ence, in the third @uarter of 155<, there has been obser4ed an increase in the /S dollar lending, in particular in the *urosystem and been smaller in the Swiss -ational ank% ank of *ngland, whereas the amount has =1559?: 15?L

,58 ,5: ,5<

(t the same time, the F.M& also appro4ed new facilities with the +eser4e ank of -ew !ealand =+ -!?, anco &entral do rasil, anco de M^Cico, the ank of "orea, and the Monetary (uthority of Singapore =F*D =155<>)+ab?% These acti4ities were the first established since ,, September 155,, when swap agreements de4oted to assist financial market functioning after the disruptions to infrastructure due to the terrorist attacks = aba 7 )acker =1559>-o%1<0?: 0?% The Fed keeps the foreign currency in an account at the foreign central bank% The dollars that the Fed pro4ides are deposited in an account that the foreign central bank maintains at the Federal +eser4e ank of -ew 6ork%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
3igure C / F$ 2ollar $wa" 1ines of *ey 'entral #anks, in billions

(t the time, the terms of the features of the agreement, the *&

could swap euro for up to N15

$ource< &-c7uire and (etercould &2009)< Swiss /9) billion, and the Sfrancs for up to N2 billion, respecti4ely, through the end of Gune

155< = aba 7 )acker =1559>-o%1<0?: 0?% (s the figure depicts, these /S dollar swap lines became unlimited to accommodate any @uantity of /S dollar borrowing =against collateral?, for the participants in the market in ,3 .ctober 155<% This eCplains the obser4ed increase mention abo4e% Aith these funds, the *& and S- were then able to temporarily lend, through auctions conducted in parallel with the Term (uction Facility =T(F? of the Federal +eser4e =as mentioned in &hapter 2?, the dollar proceeds of swaps to *urosystem and Swiss counterparties with in need of term dollar funding% .n ,: and 1, December 155:, the *& carried out fiCed rate auctions for N,5 billion of 1< day and 30 day funds, respecti4ely, were the rates was determined by the marginal rate of the same day of Federal +eser4e T(F auction% Ahile, ,: December 155:, the Stender auction for N2 billion% (ll of the auctions were completely subscribed, and therefore, by the end of the year, both the *& and S- had entirely drawn down their swap lines with the Federal +eser4e% These auctions were followed by analogous ones, which essentially rolled o4er the 1<>day swap lines by the *& in ,2 and 1< Ganuary 155<, and by the S- of ,2 Ganuary% 'ence, as the term funding pressures declined in February =as mentioned in chapter 2?, along with the FX swap market de4iations, the auctions were conse@uently suspended by the *& and S- , and thus not held in February 155< =S=1559>(ppendiC?L aba 7 )acker =1559>-o%1<0?: 0?% Ahen eCamining the effect of swap lines in the balance sheets, as illustrated in figure 9%3 in appendiC 9, the establishment of the swap lines was a 4ital dri4er of balance sheet eCpansions for maHor central banks during this period% The 4alue of FX swap was higher in the Federal +eser4e in mid 155<, and started to decrease again, when nearing year 1559% ( similar pattern was obser4ed in o* and *uropean system hence the 4alue for FX swap was higher in the *uropean system% o* compared to the held a 4ariable rate

Side 35 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management 6:(:' +""ectiveness o" the Swap 7ines (s mentioned earlier, as the dollar li@uidity matter for *uropean banks turned into a global issue, in particularly, after the $ehman default, central banks stepped in to release the market% ( number of authors ha4e eCamined the effect on the &I)% 'ui =1559? eCamines the effect of the Federal +eser4e Swap lines with other central banks on the FX swap spread% The study suggests that the Federal +eser4e Swap lines reduced the FX swap spreads in the three *uropean economies, and Gapan after the $ehman failure, whereas the impact of the Federal +eser4e dollar swap lines with the *uropean &entral ank and Swiss -ational bank on the corresponding FX swap spreads before the $ehman aba and )acker =1559b? also find failure was insignificant ='ui =1559?: ,5?% ( relati4e study by

that the /S dollar term funding auctions pro4ided by different central banks and the unlimited dollar swap lines designed by the /S Federal +eser4e had stabilising effect on the &I) de4iations = aba and )acker =1559b?: ,<?% #.4 Cooperation +ith )iscal Authorities

Taylor =1559? stress that the increased spreads in the markets were percei4ed by authorities as li@uidity issues, therefore the early inter4entions focused mainly on policies other than those which would deal with fundamental sources of heightened risk =Taylor =1559?: ,,?% (s also mentioned earlier in the footnote, the third category of policy responses recei4ed more prominence as the later stages of the turmoil, and thus, it focused on alle4iating tightening credit conditions = IS =1559abc?: ,5,?, which indicates that the reason for central banks not being able to pre4ent tensions from returning, may ha4e been that they ha4e not been focusing enough on the credit risk in4ol4ed in the spreads obser4ed in chapter 2% The central bank inter4entions addressed the immediate funding needs banks were facing in the first stages of the crisis, but with the bankruptcy of $ehman rothers in mid> 155< called into @uestion the sol4ency of a range of 4ital financial institutions ,59% Ki4en their significance to the functioning of the real economy, many go4ernments took actions to pre4ent their collapse and to restore confidence in the financial system,,5% (ccording to IS =1559abc? the go4ernment policy response had a positi4e effect in pre4enting the collapse of the financial system, and calming the markets%
,59

For instance, issues related to the /" mortgage lender radford 7 ingley, which became nationalisedL banking and insurance company Fortis recei4es a capital inHection from three *uropean go4ernmentsL Kerman commercial property lender 'ypo +eal *state secures a go4ernment>facilitated credit lineL troubled /S bank Aacho4ia is taken o4erL the proposed T(+) is reHected by the /S 'ouse of +epresentati4es%
,,5

The fact that central banks ha4e relied on balance sheet policies =see figure 'entral #ank ?ssets and 1iabilities ) has entailed a rapidly persistent role for the central bank in the intermediation process, and more remarkable influence on the relati4e supplies of claims on the public sector% &onse@uently, this has increased the need for close cooperation with the fiscal authorities for two chief reasons% First, large purchases of go4ernment securities and the associated rapid eCpansion of central bank liabilities affect the o4erall profile of public sector debt% This could result in damaged by debt management operations due to their usually large siFe, eCcept the obHecti4es of the two types of operations are consistent% The second reason is that central banks take on greater credit and market risk% (s a conse@uence, a close relation between the central bank and the go4ernment is necessary, in order to ensure that potential losses do not impair the operational independence of central banks = IS =1559>:9 th?: ,55>2?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management 'owe4er, it had less success in con4incingly addressing the impaired assets on the balance sheets of the banks, which also indicate a delay of adHustments re@uired to ensure that the financial system can operate efficiently on a sustainable basis% IS =1559abc? stress that by May 1559, doubts about the long term health of maHor global banks remained, with uncertainty regarding potential losses from loan books and other credit eCposures making it difficult for banks to raise pri4ate capital% 6:.:' )haracteristics o" !overnment rescue packa!es In late September 155< and in .ctober 155<, go4ernments of most lending economies, as shown in the table below announced comprehensi4e rescue packages% It was further stated that no 4ital institution would be allowed to fail =direct%go4%uk =1559?L bundesregierung%de =1559?L usa%go4J =1559?% This is an attempt to boost some confidence in the o4erall market% IS =1559>:9 th? stress that the rescue packages consist of actions aiming the li@uidity and sol4ency of specific institutions and the functioning of financial markets, as illustrated in figure 8%8% In contrast to the central banks had pro4ided short term funding to eligible institutions during earlier stages of the crisis, while go4ernment pro4ided access to more permanent sources of funding in the deepen period of the crisis by pro4iding deposit and debt guarantees% Ko4ernments sol4ed issues related to sol4ency by recaptilising the banks, and in an effort to address impaired assets, go4ernments either purchased assets or pro4ided insurance against eCtraordinarily large losses on particular portfolios of key institutions% Finally, central banks along with the go4ernments ha4e played a fundamental role in calming and stabilising the interbank market as well as the o4erall financial markets% &entral banks ha4e adopted a range of policies to respond to the crisis, these can be di4ided into three board types% The first category response implies measures to ensure that the market rate is near policy rates =or target rates? through more acti4e reser4e management, accordingly assuring banks of their orderly access to o4ernight funds% The second category consist initiati4es to alle4iate strains in general interbank markets i%e% term markets and repo market by increasing the a4erage maturity of refinancing pro4ided to banks, eCpanding, where needed, the range of eligible collateral and counterparties, and increase the scope of securities lending etc% The last two categories, insofar as they in4ol4e operations directed at particular segments of the transmission mechanism o4er and abo4e the traditional interest rate target, fall under the umbrella of balance sheet policy
3igure C +, $"ecial 7overnment Tools to $tabilise the financial system+

ToolsE Aovernment

/S

D*

F+

IT

-$

&'

(/

&(

G)

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Deposit insurance +estriction on short selling &apital inHections Debt guarantees (sset insurance (sset purchases -ationalisation x x x x 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 x x x x x x x 4 x x x x x x x x x x x x x x x x x x

$ource< &#!$ &2009abc)< +0,) ;ote< /S T /nited StatesL K T /nited "ingdomL D* T KermanyL F+ T FranceL IT T ItalyL -$ T -etherlandsL &' T SwitFerlandL (/ T (ustraliaL &( T &anadaL G) T GapanL x T yesL blank space T no% , +eflects information up to end>(pril 1559%

(s a last remedy, go4ernments e4en nationalised insol4ent financial institutions to protect depositiors and a4oid contagion, or ac@uired maHority e@uity stakes% More than 15 countries increased guarantees on retail and commercial deposits, reducing the probability of bank runs% Ko4ernment debt guarantees allowed eligible banks to issue new bonds supported by eCplicit go4ernment assurance in return for an annual fee paid by the issuer% Issuance under these schemes was the primary source of bank bond issuance in the last @uarter of 155< and the first @uarter of 1559% The market response to the go4ernment debt guarantee programs was slower than eCpected as issuers were discouraged by the terms and the costs% For instance, *uropean banks faced higher costs for debt guarantees compared to /S banks, while the /S charged a flat rate to all borrowers regardless of rating% The cost of *uropean guarantees was connected to past &DS spreads making them more eCpensi4e for riskier borrowers% In certain incidences, the in4ol4ed costs, made guarantees less attracti4e than short term funding through central banks% The maturities a4ailable also 4aried by country, usually from three to fi4e years, with most banks issuing at the longest maturity a4ailable% The complication related to the guarantees programs and the 4arying treatment across Hurisdictions discouraged some in4estors,,,% Ko4ernments recapitalised the banks to reduce their financial le4erage and increase their sol4ency% /" Treasury applied common shares, whereas most go4ernments bought hybrid securities,,1 such as preferred shares or mandatory con4ertible notes% The go4ernment capital inHections had issues attached% &ertain conditions were difficult to enforce due to lack of precision and unwillingness or inability to interfere in the management of the banks% For instance, many rescue packages outlined general restrictions on eCecuti4e pay, hence go4ernments lacked 4otes, the support of the boards of
,,,

The risk weighting on go4ernment>guaranteed bonds 4aries across countries, with some regulators treating them as riskless from a capital perspecti4e and others assigning a 15E capital charge% -ot all markets accepted guaranteed debt as collateral% Some in4estors also faced legal or operational restrictions that pre4ented them from buying this new asset class%
,,1

'owe4er, hybrid securities are not percei4ed with much confidence by market participants due to their limited ability to absorb losses, e4en though they may @ualify as e@uity when the regulatory ratio of a bank is calculated%

Side 33 af '''

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management the banks, and the legal basis to block payments% ( small number of go4ernments supported key financial institutions by purchasing impaired assets or offering insurance against losses% *%g% the Sbought mortgage related assets from / S and positioned them in a special in4estment ank of (merica and &itigroup ,,2% IS =1559abc? emphasise that by 4ehicle,,3% The Dutch, /" and /S go4ernments also offered asset insurance to a few banks i%e% I-K, + S, $loyds TS , limiting the potential losses of the banks, asset insurance reduces the capital it must hold% 'owe4er, the go4ernments are left with a great possible liability gi4en the assets fall to a large eCtent in 4alue% (t last, go4ernments in Iceland, Ireland, the /nited "ingdom and the /nited States o4ertook a range of insol4ent financial institutions to protect depositors and to pre4ent contagion to other financial institutions,,0 = IS =1559abc?: ,55>,58?% -arket reaction to rescue "ackages (ccording to IS =1559abc? the go4ernment inter4entions in late September and .ctober 155< a4erted bankruptcies at key banks and protected depositors but did not entirely dispel health concerns of maHor global banks% -e4ertheless, as also reflected in figure 2%0 there has been a narrowing of credit spreads, howe4er, IS =1559abc? stress that most banks still found it difficult or impossible to raise new capital from pri4ate in4estors% (s a whole, IS =1559abc? highlight that go4ernments may not ha4e acted promptly enough, go4ernment rescue packages reduced the probability of default, pushing down &DS premia on a4erage = IS =1559abc?: ,,5?%

,,3

The sale reduced the risk weighted assets of / S, lowered the amount of regulatory capital it must hold against potential losses% Despite that fact S- bears the risk of losses, it also shares in the profits if the assets reco4er% 114 These schemes in4ol4esL go4ernments assume a share of the potential losses on a particular portfolio, generally <5>95 percent after a first loss amount =or deductible? is absorbed by the bank% In reply, banks pay the go4ernment an insurance premium based on the riskiness of the portfolio%
,,0

The control transfers was accomplished directly by regulators through e%g% /S go4ernment sponsored enterprises and Icelands banks, or through court inHuction, as was the case of radford and ingley in the /$ and the elgo>Dutch firm Fortis% In other situations, it was accomplished indirectly by ac@uiring the maHority or entirely of the 4oting shares such as with (IK and + S% The legal set up for regulatory for takeo4ers eCist already in the /S, but new law ha4e to be passed in Kermany and /" to facilitate these actions, which in the other hand might be blocked by shareholders%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

)/A*T+0 2:

)/A*T+0 2: *+0S*+)TI@+

In (pril 1559, at the $ondon Summit, the K15 gathered to discuss what was achie4able at the international le4el in terms of financial super4ision as no global bodies in the realm of financial super4ision had any legal powers% K15 agreed principles for handling globally with impaired assets, repairing the financial system to restore lending, strengthening financial regulation to rebuild trust, and funding and reforming international financial institutions, both to o4ercome the current and to pre4ent future crisis% In an attempt of dealing with this, the new Financial Stability oard =FS ? ,,8 was established with a supported mandate as a successor to the Financial Stability Forum, to eCtend regulation and o4ersight to all central financial institutions, instruments, and markets and to reinforce international standards of prudential regulation ='ouse of &ommons =1559?: 20?% Mario Draghi &hairman of the Financial Stability Forum, sums the obHecti4e of FS
,,:

as to

promote and assist to coordinate alignment of international standard setting acti4ities to address o4erlaps or gaps in national regulatory structures relating to prudential and systemic risk, market integrity and consumer protection, infrastructure, and accounting and auditing% In addition, the FS aims to set up regional outreach acti4ities to broaden the circle of countries engaged in work to promote international financial stability% Furthermore, as a result, the FS and IMF will collaborate closer, each complementing the role of the other% Those two bodies are to collaborate in conducting *arly Aarning *Cercises and make a Hoint presentation to the International Monetary and Financial &ommittee =IMF&? on financial risks and 4ulnerabilities and policy recommendations to mitigate such risks =FS( =1559?: 3?% (t the $ondon Summit, it was argued that the new global framework would be agreed at the */ le4el, and thereby highlighted the role of */% +eforms to financial regulation ha4e been presented by the report of the 'igh>$e4el Kroup on Financial Super4ision in the */, chaired by Gac@ues de $arosi_re% In February 1559, the report proposed a new framework for *uropean Super4ision, to reduce risk and impro4e risk management, reduce procyclicality, impro4e systemic shock
,,8

The Financial Stability Forum =FSF? has been relaunched as the Financial Stability oard =FS ?, with an eCpanded membership and a broadened mandate to promote financial stability% FS emerged towards placing the FSF on stronger institutional ground to strengthen its effecti4eness as a mean for national authorities, standard setting bodies and international financial institutions to address 4ulnerabilities and to de4elop and implement regulatory, super4isory and other policies in the interest of financial stability =FS( =1559?: ,?%
,,:

The following countries and territories are represented on the FS : (rgentina, (ustralia, raFil, &hina, &anada, France, Kermany, 'ong "ong S(+, India, Indonesia, Italy, Gapan, "orea, MeCico, the -etherlands, +ussia, Saudi (rabia, Singapore, South (frica, Spain, SwitFerland, Turkey, the /nited "ingdom, and the /nited States% The following institutions, standard>setting bodies and other groupings are also members of the FS : the ank for International Settlements, *uropean &entral ank, *uropean &ommission, International Monetary Fund, .rganisation for *conomic &o> operation and De4elopment, Aorld ank, asel &ommittee on anking Super4ision, International (ccounting Standards oard, International (ssociation of Insurance Super4isors, International .rganiFation of Securities &ommissions, &ommittee on the Klobal Financial System, and &ommittee on )ayment and Settlement Systems =FS( =1559?: 3?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management absorbers, impro4e financial markets incenti4es, strengthen the coordination of super4ision between national authorities and the establishment of crisis management procedures ='ouse of &ommon =1559?: 22?% (s a result of this, in Gune 1559 the *uropean &ouncil =*&? established the *uropean Systemic +isk oard =*S+ ?,,<, which will monitor and assess potential threats to financial stability and, where necessary issue risk warnings and recommendations for action and monitor their implementations =&ouncil of the *uropean /nion =1559?: :?L *uropean &ommission =1559)+?: <>9?% (lready in 1555, (ndrew &rockett, the pre4ious Keneral Manager of the ank for International Settlements and &hairman of the Financial Stability Forum, raised the need for super4isory policy limiting the possibility of the failure and corresponding costs, of 4ital portions of the financial system =&rockett =1555?: ,?% Furthermore, three *uropean super4isory authorities, dealing with the banking, insurance and securities industries, working close to national super4isors, among other things in preparing technical standards, ensuring consistent application of */ law and resol4ing disputes between national super4isors% The three new *uropean Super4isory (uthorities will replace the eCisting */ &ommittees of super4isors, which will be charged with ensuring that a 6single set of harmonised rules and consistent su"ervisory "ractices is a""lied by national su"ervisors= =*uropean &ommission =1559)+?: ,,?% $ord Turner of *cchinswell, the &hairman of the Financial Ser4ices (uthority, further states that the obHecti4e of the new bodies are to put pressure on the regulators in small countries to ensure tight standards are applied and not to dictate regulators in large countries such as the FS( what to do ='ouse of &ommons =1559?: 28?% $orenFo =1559? stress the importance of these reforms, especially against the background of the financial crisis that faced in the summer of 155: =$orenFo =1559?: ,?% The enthusiasms for the new body, *S+ was re4ealed by a remark by $ord Turner of *cchinswell, the &hairman of the Financial Ser4ices (uthority as the followingL 68hether this body turns out to be a mere talking sho" or a useful talking sho", in terms of an exchange of views and ideas being generated, remains to be seenNthat is u" to the "eo"le who sit on it 8e will see ! go to vast numbers of international meetings and ! cannot claim that most of them live u" to the billing that one would ho"e ;evertheless, as ! said, ho"e s"rings eternalNcautious, moderate ho"e for this committeeNand we
,,<

The members of the Keneral &ouncil of the *& will elect the chair of the *uropean Systemic +isk oard, which also means that the interest of the *& will be persuade in these reforms =&ouncil of the *uropean /nion =1559?: :?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management will do our best to try and raise the level of debate= ='ouse of &ommon =1559?: 22?% This remark is @uite interesting, as it mirror concerns in these types of international meetings, in particular with the new scale of work in4ol4ed% .n 18>1: Gune, the FS held its first inaugural meeting in asel, since the re>establishment as the FS
,,9

The FS

established a &ross>border &risis Management Aorking Kroup, under the

Standing &ommittee for Super4isory and +egulatory &ooperation% The working Kroup is chaired by )aul Tucker, Deputy Ko4ernor of the o*, who will work to pro4ide a framework to implement the FSF )rinciples for &ross> order &ooperation on &risis Management =FS =1559>)+?: 1?% For instance, in managing a financial crisis, authorities will endea4our to find internationally coordinated solutions that take account of the impact of the crisis on the financial system and real economies of other countries% Moreo4er, to share information freely as feasible with rele4ant authorities from an early stage, and if a fully coordinated solution is not possible, a discussion as promptly as possible% Finally, for the purpose of clarity and coordination, to share plans for public communication with appropriate authorities =FS =1559?: 3>2?% (s also reflected in pre4ious chapter, the FS also mentioned signs of impro4ements in the global macroeconomic outlook and in certain financial markets, in particular funding markets =Fed =1559> (ug?: ,?% anks ha4e managed to raise capital from the pri4ate sector, but restricting and strengthening bank balance sheets is not yet completed% It is further emphasised that, in order to support sustained reco4er, bank lending needs to be strengthened% The FS assigned a number of obHecti4es since (pril 1559 e%g% it welcomed the I.S&. work to de4elop recommendations on regulatory approaches to securitisation and credit default swap markets% This is to be publicated in the I.S&. report in September 1559% Furthermore, national and regional initiati4es are going on to strengthen o4ersight of credit rating agencies% In addition, the FS is to publish later in this year, the work by the Goint Forum to analyse regulatory gaps and propose solutions, in order to ensure that the nature and scope of regulation across banking, insurance and securities markets are consistent and appropriate etc =FS =1559>)+?: 1?%

119

(t this meeting, the FS set up the internal structures needed to fulfill its mandate, also risks and challenges facing financial systems was discussed, along with the progress of implementing FSb and K>15 recommendations =FS =1559>)+?: ,?%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management )/A*T+0 3: )/A*T+0 3: )1,)7#SI1,

(s a conclusion the thesis has described and analysedJdiscussed the tension in the international interbank and FX swap markets in the time period of 155:>1559, which was followed by a discussion of the role of the central bank actions% The thesis has said out underlying dynamics behind the tensions eCperienced in the international interbank and FX swap markets% The Statistics part illustrated the measures for li@uidity in the interbank markets, which has been reflected in the $ibor>.IS spreads, and the term markets% Moreo4er, measures for credit spreads ha4e been mirrored in the Fi4e>year bank credit default swap =&DS? spreads for selected banks in the /S, /" and *urope% The li@uidity measure in the FX swap market has been reflected in the spread between FX swap>implied rates and $ibor% (ll of the measures showed an increase in the spreads in (ugust 155:, and a heightened increase in the fourth @uarter of 155<, after the $ehman rothers bankruptcy% .n the 9 (ugust the first signals were obser4ed in the interest rate on o4ernight loans between banks, which increased unusually high le4els for many international markets, such as the /S, *urope, /" and Gapan% The /S, *uro, /" and 6en $ibor> .IS spreads increased from < bps% to ,13 bps%, fi4e bps% to maCimum of ,<8 bps%, from 8 bps% to ,80 bps%, and from ,8 bps% to :3 bps%, respecti4ely, in the fourth @uarter of 155<% Ahen eCamined the unsecured and secured spreads, a similar pattern of increased spreads was obser4ed after the default of $ehman rothers% Ahile, the term rates a pattern of higher acti4ity in the short term rates, in contrast to the longer term rates% In the second @uarter of 155<, o4ernight acti4ities represented around :5 percent of the total lending and borrowing acti4ity in the *uropean unsecured market% Furthermore, the statistics ha4e shown credit default swaps spreads as a measure of default risk of banks in institutions in /S, *uro area and the /"% The initial increased was obser4ed already in Guly of 155: where the spread was less than ,55 bps% 'ence, also in here, the first maHor increases occurred in 155< for all the economies% The /S spread was obser4ed to be around 195 bps%, whereas the *uro and the /" were less than 155 bps% In4estigating the eCternal en4ironments, issues related to international financial institutions seems to play a role behind the high &DS spreads obser4ed% ( second spread occurred with the $ehman default, where the spread approCimated 855 bps% in the /S, whereas in the *uro area and the /" , the spread increased to around 155 bps%, and 355 bps% respecti4ely%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management (gain the statistics showed the three> month, siC>month and ,1> month /S funding rate implied from the FX swaps in */+, K ) and G)6, which after 9 (ugust 155: showed an upward trend% The spreads between the FX swap>implied dollar rates and dollar $ibor also increased, mo4ing from Guly le4els, i%e% close to 30 bps in the euro, 10 basis points in sterling, and ,0 basis points in the yen% (necdotal e4idence suggest *uropean financial institutions that needed /S dollars, hence faced keen concerns o4er their own credit risk in dollar cash markets, turned to the FX swap market to raise dollars using both the euro and sterling as funding currencies, which was reflected in the FX swap price i%e% de4iation from &I) condition% (nalysing the underlying dynamics obser4ed in chapter 2, li@uidity hoarding ha4e been presented as a trigger for the tension in the interbank market, which e4entually spilled o4er to short term FX swap markets% The maHority of empirical studies support the fact that both factors i%e% credit and li@uidity risk played a rele4ant role in the financial crisis 155:>1559 in the interbank markets, which was obser4ed in chapter 2% It has been argued that if li@uidity was the only eCplanation for the tension, central banks should ha4e been able to @uickly restore normal conditions by inHections of great amounts of li@uidity, and make the supply of bank reser4es meet the le4el demanded by the banking system% Moreo4er, if credit risk were the only eCplanation, it would be difficult to eCplain the noteworthy differences across market segments, especially why the short term segment has been rather resistant from the crunch, and why banks should lend short term at normal rates, if it its belie4ed that counterparty may not be able to repay% Furthermore, funding sources switched from 4ery short term borrowing, where the main maHority of o4erall unsecured acti4ity usually takes place, to secured longer term instruments, which suffered from a less se4ere li@uidity strain than the unsecured interbank deposit segment% There has been a general decline in unsecured transaction 4olumes, hence an increase of 3, percent in borrowing transactions for maturities longer than one month% It is stressed that a significant aspect of the turmoil was due to shortage of dollar funding for many institutions, in particular *uropean institutions was the factor that triggered the spill o4er to the international FX swap markets% (t the end of September 155<, the interbank markets were shut down, and banks sought dollar financing elsewhere%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management In the third @uarter of 155<, the interbank lending continued to contract, also indicating the ongoing tensions in interbank credit markets% There has been obser4ed a reduction of the interbank lending, in particular by French, elgian and Kerman banks, which accounted for much of the decline% French anks reported a decline to around N105 billion, whereas Kerman banks a bit less than N105 billion% These two banks were also those with the highest consolidated foreign claims compared to the elgian banks, which only reported around N855 billion in the beginning of 155<, but suffered a decline in the foreign claims of around N,55 billion% Furthermore, only a slight decline for the interbank lending for Swiss banks ha4e been obser4ed compared to the other *uropean banks% SubHect to this critical demandJsupply conditions in the interbank market, many non>/S financial institutions endea4oured to con4ert euro into dollar li@uidity through FX swaps, one of the most li@uid financial markets% The underlying factors obser4ed in the FX swap spread i%e% de4iations from &I) conditions has been a great discussion% In the theoretical framework, it has been stressed that &I) to hold strictly depends on negligible, in particular with credit risk, li@uidity risk measurements errors, transaction costs and political risk% 'ence, as obser4ed in chapter 2, li@uidity and credit risk ha4e played a significant role in the recent turmoil% +ecent empirical studies ha4e shown similar conclusions% It has been emphasised that de4iations from the &I) in the *uro FX swap market has been due to reassessment of counterparty risk based on the data from (ugust 155: to September 155<% It is to be remarked that due to una4ailable data after September 155< is lacking in se4eral studies% 'ence, a more recent study finds that the early stage of the crisis i%e% prior to the $ehman default, for euro, pound, Swiss franc and yen, the funding li@uidity was the maHor concern and main determinant of the changes in the &I) =measured by the $iborJ.IS spread?% 'owe4er, eCamining the time period after the default of the $ehman rothers another pattern shows as eCplanation for the spread in the FX swap implied /S dollar rates i%e% &I) de4iation% The funding li@uidity risk remained a 4ital factor behind the FX swap spread, despite a fall occurred in the eCplanatory power for the euro, pound, Swiss franc and yen% In addition, counterparty risk became a significant eCplanation factor, after the $ehman default in the *uropean economies in the &I) de4iations for euro, pound and Swiss franc, which increased the premiums on the swap implied /SD interest rate%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management

Due to 4ery limited empirical studies other factors such as transaction costs, data imperfections ha4e not been in4estigated with data from 155:>1559, and therefore, the effect on the crisis ha4e not been able to be identified in more details% Furthermore, under turmoil there has been eCistence of short term de4iations of &I) in the FX swap market, hence analysing the time frame for the spread in chapter 2, it was ob4ious that the spread took longer time than usual, as it is assessed that de4iations in the *uro>market are in general eliminated within two days it can take up to se4eral weeks for &anada and the /%S% Finally, central banks along with the go4ernments ha4e played a fundamental role in calming and stabilising the interbank market as well as the o4erall financial markets% &entral banks ha4e adopted a range of policies to respond to the crisis, these can be di4ided into three board types% The first category of responses implies measures to ensure that the market rate is near policy rates =or target rates?% The second category consist initiati4es to alle4iate strains in general interbank markets i%e% term markets, increasing the a4erage maturity of refinancing pro4ided to banks, eCpanding, where needed, the range of eligible collateral and counterparties, swap lines etc% 'ence, go4ernment remedies were also enforced as a remedy to battle the credit risk in the o4erall market% Few go4ernments supported key financial institutions by purchasing impaired assets or offering insurance against losses% The market reaction on the go4ernment inter4entions in late September and .ctober 155< a4erted bankruptcies at key banks and protected depositors but did not entirely dispel health concerns of maHor global banks% 'ence, go4ernment rescue packages reduced the probability of default, pushing down &DS premia on a4erage In (pril 1559, at the $ondon Summit, the K15 gathered to discuss the global turmoil%K15 agreed principles for handling globally with impaired assets, repairing the financial system to restore lending, strengthening financial regulation to rebuild trust, and funding and reforming international financial institutions, both to o4ercome the current and to pre4ent future crisis% In an attempt of dealing with this, the new Financial Stability oard =FS ? was established% (s a result of this, in oard =*S+ ?, Gune 1559 the *uropean &ouncil =*&? established the *uropean Systemic +isk which will monitor and assess potential threats to financial stability%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management .n 18>1: Gune, the FS held its first inaugural meeting in asel, since the re>establishment as the FS % The FS announced signs of impro4ements in the global macroeconomic outlook and in certain financial markets, in particular funding markets but it is further emphasised that, in order to support sustained reco4er, bank lending needs to be strengthened%

)/A*T+0 &: -oo(s&

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Arabbe, 4: 1rlin! <'&&6=: 6!nternational 3inancial -arkets=, Third *dition, )rentice 'all, *nglewood &liffs, -ew Gersey Aabriele Aalati and Ale>andra /eath <$%%2=: 68hat drives the growth in 34 activity: !nter"reting the 2007 triennial survey=, IS Wuaterly +e4iew, December 155: Aallati, 0eto <$%%(=: M.isk -anagement and 'a"ital ?de%uacy = lacklick, .', /S(: McKraw> 'ill &ompanies% /anaCiri, T <'&&&=: 6Three Ia"an "remiums in autumn +997 and autumn +99> @ 8hy did "remiums differ between markets=, #ank of Ia"an 3inancial -arkets 2e"artment 8orking (a"er $eries no 99>*>,% /e""erman, Shela!h <$%%5=: 6-odern #anking=, Gohn Ailey 7 Sons, $td% /ille , 4ohn 7, Beidleman, )arl 0: & Areenlea", 4ames A: <'&2&=: 62oes 'overed !nterest ?rbitrage 2ominate in 3oreign Exchange -arkets:=,&olumbia Gournal of Aorld usinessL Ainter :9, ;ol% ,2 Issue 2, p% 99>,5:, 9p, 3 charts% /orcher, 9aren A: <$%%5=: MEssentials of 3inancial .isk -anagement = Gohn Ailey 7 Sons, Incorporated 9e nes, 4ohn Ma nard <'&$.=: 6? Tract on -onetary .eform=, ;olume I;, MacMillan St% MatinDs )ress 7evinson, Marc <$%%5=: L7uide to 3inancial -arketsL, )rofile ooks $imited, )ages: 108, IS -: 9:<,<8,9:908< 9:<,<2:80511, 7lo d B: Thomas <'&&2=: -oney, #anking, and 3inancial -arkets, International *dition, "ansas State /ni4ersity, The McKraw>'ill &ompanies, Inc% Madura, 4e"" <$%%%=: 3inancial -arkets and !nstitutions, Fifth *dition, Florida (tlantic /ni4ersity, South>Aestern &ollege )ublishing McAuire, *:, von *eter, A: <$%%&=: 6The F$ 2ollar $hortage in 7lobal #anking=% IS Wuarterly +e4iew =March?, 2:>83% McAuire, *:, von *eter, A:<$%%3=: M!nternational #anking ?ctivity amidst the Turmoil= % Wuarterly +e4iew =Gune?, 3,>23% Moosa, Imad A: <$%%(=: M!nternational 3inancial 0"erations < ?rbitrage, 9edging, $"eculation, 3inancing and !nvestment=, Kordons4ille, ;(, /S(: )algra4e Macmilla% 0everre, Stephane <$%%'=: M'om"lete ?rbitrage 2eskbook=, lacklick, .', /S(: McKraw>'ill &ompanies% Sti!um, M and A )rescenFi <$%%2=: $tigum5s money market, fourth edition, McKraw 'ill%
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management @an Areunin!, /ennie <$%%(=: M?nalyAing and -anaging #anking .isk < ? 3ramework for ?ssessing 'or"orate 7overnance and 3inancial .isk &2nd Edition)= Aashington, D&, /S(: Aorld ank )ublications% Articles& Adler, M: and -umas, 0: <'&26=: L(ortfolio 'hoice and the 2emand for 3orward Exchange L (merican *conomic +e4iew =Ma4 ,9:8? pp% 331>339 Adrian T: and Shin /: S: <$%%3=: L1i%uidity and leverageL% Gournal of Financial Intermediation, doi:,5%,5,8JH%Hfi%155<%,1%551 A!mon, T: and Bron"eld, S: <'&25=: 6The international mobility of short-term arbitrage ca"ital = Gournal of usiness Finance and (ccounting, 4ol% 1, pp% 189>:< Akerlo", A: A: <'&2%=: 6The -arket for M1emonsM< Huality Fncertainty and the -arket -echanism=, Wuarterly Gournal of *conomics, <2=3?: 2<<>055 Aliber, 0obert G: <'&2(=:=The !nterest .ate Theorem< ? .einter"retation= G%)%*% <,, no% 8, =-o4emberJDecember?, pp% ,20,>09 Allen, F: and )arletti, +: <$%%3=: LThe .ole of 1i%uidity in 3inancial 'risesL, Gackson 'ole Symposium on Maintaining Stability in a &hanging Financial System, (ugust 1,>13 Allen, Franklin, )arletti, +lena and -ou!las Aale <$%%3=: 6!nterbank -arket 1i%uidity and 'entral #ank !ntervention=, )repared for the &arnegie>+ochester Series on )ublic )olicy &onference in -o4ember 155< Andersen, Sparre, 9ristian and MatFen, Anders <'&&3=: 6The use of .atings in the Euro"ean 'a"ital -arkets=, Danmarks -ationalbank, Monetary +e4iew, 3rd Wuarter% Ashcra"t, Adam B: and Schuermann, Til <$%%3=: 6Fnderstanding the $ecuritisation of sub"rime -ortgage 'redit=, Federal +eser4e ank of -ew 6ork Staff +eport -o%3,< Atkins F4 <'&&(=: 6The dynamics of adjustment in deviations from covered interest "arity in the Euromarket< Evidence from matched daily data = (pplied Financial *conomics 3:,<3>,<: Atkins F4 <'&&'=: 6'overed interest "arity between 'anada and the Fnited $tates< ?nother look using modern time series methods = *mpirical *conomics ,8:310>332 Baba, ,: <$%%&=: 62ynamic $"illover of -oney -arket Turmoil from 34 $wa" to 'ross- 'urrency $wa" -arkets< Evidence from the 2007-200> Turmoil #, Gournal of FiCed Income ,< =2?, 12> 3<% Baba, ,:, Mc)aule , 0: ,: and 0amaswam , S: <$%%&=: 6F$ 2ollar -oney -arket 3unds and ;on-F$ #anks=% IS Wuarterly +e4iew =March?, 80><,%
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Baba, ,: and *acker, F: <$%%&a=: 6!nter"reting 2eviations from 'overed !nterest (arity 2uring the 3inancial -arket Turmoil of 2007-0>#% Gournal of anking and Finance, forthcoming% Baba, ,: and *acker, F: <$%%&b=: M3rom turmoil to crisis< dislocations in the 34 swa" market before and after the failure of 1ehman #rothers=, IS Aorking )apers -o%1<0, Monetary and *conomic Department% Baba, ,:, *acker, F: and ,a!ano, T: <$%%3=: 6The s"illover of money market turbulence to 34 swa" and cross-currency swa" markets=, IS Wuarterly +e4iew, March 155<, :3><8% Ba!lioni <$%%&=: 61i%uidity 'runch !n The !nterbank -arket< !s !t 'redit 0r 1i%uidity .isk, 0r #oth:L Guly 1559, &atholic /ni4ersity Milan, working papers series 18 Ba!lioni A: B Monticini A: <$%%3 a=: LThe intraday "rice of money< evidence from the e--!2 interbank market`, Gournal of Money, &redit and anking, 25=:?, ,033>,025% Ba!lioni A: B Monticini A: <$%%3 b=: LThe intraday interest rate under a li%uidity crisis< the case of ?ugust 2007`, Mimeo% Balke, , and 8ohar, M: <'&&3=: 6;onlinear dynamics and covered interest rate "arity=, *mpirical *conomics, 13, 030>>09% Beber, Alessandro, Brandt, Michael 8: and 9avaCecF, 9enneth A: <$%%6=: 63light-to-Huality or 3light-to-1i%uidity: Evidence from the Euro-?rea #ond -arket =, - *+ Aorking )aper =Gune 1558?% Bhattachar a, S: and Ful!hieri, *: <'&&.=: LFncertain 1i%uidity and !nterbank 'ontractingL, *conomics $etters 22, 1<:>192% Bhattachar a, S: and Aale, -: <'&32=: 6(reference $hocks, 1i%uidity, and 'entral #ank (olicy in=, A% arnett and "% Singleton =eds%? -ew (pproaches to Monetary *conomics, &ambridge /ni4ersity )ress, &ambridge% Blaise AadanecF, 4acob A ntelber! and *atrick McAuire <$%%&=: 69ighlights of international banking and financial market activity=, IS Wuarterly +e4iew March 1559 Borio, ) and ,elson, 8 <$%%3=: 6-onetary o"erations and the financial turmoil=, IS Wuarterly +e4iew, March 155<, pp 3,V28 Branson, 8illiam /: <'&6&=:6The minimum 'overed !nterest 2ifferential ;eeded for !nternational ?rbitrage ?ctivity=, G%)%* ::, -o%8 =-o4emberJDecember? Brunnermeier, M: <$%%&=: 62eci"hering the 2007-0> 1i%uidity and 'redit 'runch=, Gournal of *conomic )erspecti4es, forthcoming

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Brunnermeier, Markus 9: and *edersen, 7asse /eCe <$%%3=:6-arket 1i%uidity and 3unding 1i%uidity=, +FS (d4ance (ccess published December ,5 )hatterCi, Aaron 9: and To""el, Michael 8: <$%%&=: 69ow 3irms .es"ond to #eing .ated=, Aorking )aper, 'arward usiness School )antor, 0:, and F: *acker <'&&2=: 62ifferences of 0"inion in the 'redit .ating !ndustry =, Gournal of anking and Finance 1, =,5?, pp% ,390>,2,:% )ecchetti, Stephen A: <$%%3=: 6-onetary (olicy and the 3inancial 'risis of 2007-200> = mimeo, randeis International usiness School =March ,3? )linton, 9: <'&33=: 6Transactions costs and covered interest arbitrage< theory and evidence%# Gournal of )olitical *conomy, 98, 30<>>:5 )ook, Timoth H: and 7aroche, 0obert 9: <'&&(=: 6!nstruments of the -oney -arket6, :th *dition, Federal ank of -ew 6ork% )ouncil o" the +uropean #nion <$%%&=: M(residency 'onclusions=, russels, ,5 Guly 1559 )rockett, Andrew <$%%%=: 6-arrying the micro- and macro-"rudential dimensions of financial stability= Keneral Manager, ank for International Settlements &hairman, Financial Stability Forum, asel, SwitFerland, 1, September 1555 -avid, Aikman <$%%3=: 6'omments on< O3inancial &in)stability, su"ervision and li%uidity injections< a dynamic general e%uilibrium a""roach=, ank of *ngland 3 Guly 155< && SJAK*M Aorkshop: Financial Sector in Macro>Forecasting -udle , 8illiam ) <$%%&=: 6The 3ederal .eserveMs li%uidity facilities= IS +e4iew 2<J1559, Ailliam & Dudley, )resident and &hief *Cecuti4e .fficer of the Federal +eser4e ank of -ew 6ork, at the ;anderbilt /ni4ersity &onference on Financial Markets and Financial )olicy 'onoring Dewey Daane, -ash4ille, Tennessee, ,< (pril 1559 -u""ie, -arrell and Sin!leton, 9enneth, 4: <'&&&=: 6-odeling Term $tructures of 2efaultable #onds=, The +e4iew of Financial Studies, ;ol% ,1, -o% 2 =,999?, pp% 8<:>:15 +isenschmidt and Tapkin! <$%%&=: M1i%uidity risk "remia in unsecured !nterbank money markets= Aorking )aper Series -o% ,10, March 1559, *uropean &entral ank% Faroo; Akram <a=, -a!"inn 0ime <a= and 7ucio Sarno <a,b= <$%%6=: 6?rbitrage in the 3oreign Exchange -arket< Turning on the -icrosco"e= a: -orges ank, b: /ni4ersity of Aarwick and &*)+, February 1558 Financial Times <$%%3=: 6-oney market on strike=, 9 -o4ember 155< http:JJblogs%ft%comJeconomistsforumJ155<J,,Jmoney>market>on>strikeJ
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Flanner M: <'&&6=: 63inancial crises, "ayment system "roblems, and discount window lending=, Gournal of Money, &redit and anking, 1<=2?, <52><12% Frenkel, 4akob A: <'&2(=: 6Elasticties and the !nterest .ate (arity Theory=, G%)%* <,, -o%3 =MayJGune?, pp% :2,>2: Frenkel, 4: and 7evich, 0: <'&25=: 6'overed interest arbitrage< unex"loited "rofits:=, Gournal of )olitical *conomy, <3, 310>>3< FSA <$%%&=: 6.e-establishment of the 3$3 as the 3inancial $tability #oard=, )repared remarks by Mario Draghi &hairman of the Financial Stability Forum, (t conclusion of $ondon Summit, 1 (pril 1559 FSB <$%%&=:M3$3 (rinci"les for 'ross-border 'oo"eration on 'risis -anagement=, 1 (pril 1559% AadanecF, B <$%%.=: 6The syndicated loan market< structure, develo"ment and im"lications=, IS Wuarterly +e4iew, December, pp :0V<9 Aallanis, Mike <$%%&=:=-arket Turmoil< The TreasurerBs (oint of Piew=, Financial *Cecuti4e, 4ol 10, p%8,>81 Areenspan, Alan <$%%&=: 67reens"an5s 1ibor #arometer $hows -arkets $tay 3roAen &F"date,)=, by Ka4in Finch and $iF &apo Mc&ormic, loomberg A ntelber! 4acob and *hilip 8ooldrid!e <$%%3=:6!nterbank rate fixings during the recent turmoil=, IS Wuarterly +e4iew, March 155< /ouse o" )ommons <$%%&=: M#anking 'risis< regulation and su"ervision=, Fourteenth +eport of Session 155<V59, 'ouse of &ommons Treasury &ommittee, 3, Guly 1559, $ondon /ieder et al <$%%&=: M1i%uidity 9oarding and !nterbank -arket $"reads< The .ole of 'ounter"arty .isk=, (pril ,, 1559, *uropean anking &enter Discussion )aper -o% 1559>,,S /eider, Florian , /oerova, Marie and /olthausen, )ornelia <$%%&=:61i%uidity 9oarding and !nterbank -arket $"reads< The .ole of 'ounter"arty .isk=, , (pril 1559, *uropean anking &enter Discussion )aper -o% 1559>,,S /ui, )hoB/oi, Aenber!, /ans and )hun! TsFB9in <$%%&=: 63unding 1i%uidity .isk ?nd 2eviations 3rom !nterest-.ate (arity 2uring The 3inancial 'risis 0f 2007-2009 = Aorking )aper ,3J1559, 35 Guly 1559, 'ong "ong Monetary (uthority /Irdahl, *eter and 9in!, Michael 0 <$%%3=: 62evelo"ments in re"o markets during the financial turmoil=, IS Wuarterly +e4iew, December 155<%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management 4oJo F: )occo, Francisco 4: Aomes, ,uno ): Martins <$%%&=:61ending relationshi"s in the interbank market= G% Finan% Intermediation Interbank markets play a central role in distributing li@uidity across the financial system =&occo et al% =1559?:28? 4uhl, Ted, Miles, 8illiam and 8eidenmier, Marc -: <$%%.=: 6'overed !nterest ?rbitrage< Then versus ;ow=, *conomica =1558? :3, 32,a301, The $ondon School of *conomics and )olitical Science 1558 7evich, 0: M: <'&35=: 6Em"irical $tudies of Exchange .ates< (rice #ehaviour, .ate 2etermination and -arket Efficiency=, In =+% A% Gones and )% % "enen, eds%?, 'andbook of International *conomics, 4ol% 1% (msterdam: -orth>'olland% 7on!sta"", Francis A:, Mithal, SanCa , and ,eis, +ric <$%%5a=: L'or"orate yield s"reads< 2efault risk or li%uidity: ;ew evidence from the credit-default swa" market `, Iournal of 3inance 00, 11,3>1103 7on!sta"", Francis A: <$%%5b=: 6?sset (ricing in -arkets with !lli%uid ?ssets = Aorking )aper =Gune 1550b? 7orenFo, Bini Sma!hi <$%%&=: 67oing forward @ regulation and su"ervision after the financial turmoil=, Member of the *Cecuti4e oard of the *uropean &entral ank, at the 2th International &onference of Financial +egulation and Super4ision M(fter the ig ang: +eshaping &entral anking, +egulation and Super4ision#, occoni /ni4ersity, Milan, ,9 Gune 1559 1""icer, 7awrence /:, and 8illet, Thomas -: <'&2%=:6The 'overed-?rbitrage $chedule< ? 'ritical $urvey of .ecent 2evelo"ments = G% Money, &redit and anking 1, no%1 =May?, 12:> 10: Mc)aule , 0 , <$%%'=:6#enchmark ti""ing in the money and bond markets=, IS Wuarterly +e4iew, March, pp 39V20% McAndrews, 4ames, Sarkar, Asani and 8an!, Ghen u <$%%3=:LThe Effect of the Term ?uction 3acility on the 1ondon !nter-#ank 0ffered .ateL, Federal +eser4e ank of -ew 6ork Staff +eport 330% Mehlb e, *alle -uvier and Topp, 4acob <'&&6=: =Fdviklingen "Q "engemarkedet=, )engepolitisk "ontor, Danmarks -ationalbank Melvin, M:, Ta lor, M: *: <$%%&=:6The 'risis in the 3oreign Exchange -arket=% Gournal of International Money and Finance, forthcoming%

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Michaud, FB7 and ) #pper <$%%3=: 68hat drives interbank rates: Evidence from the 1ibor "anel=, #!$ Huarterly .eview, March, pp 2:V0<% Michael, 9empa <$%%3=: M1i%uidity crisis in the interbank market=, 3rd Gune 155<, Swedish School of *conomics and usiness (dministrationL /ni4ersity of 'elsinki *aul Tucker <$%%&=:63inancial $tability, #ank of England= )aul Tucker Deputy Ko4ernor, at the ritish ankersD (ssociation (nnual International anking &onference: +estoring &onfidence V Mo4ing Forward, $ondon 35 Gune 1559 *ippen!er 4 <'&23=:L!nterest ?rbitrage between 'anada and the Fnited $tates< ? ;ew (ers"ectiveL, &anadian Gournal of *conomics =May ,9:<?: ,<3>,93% *rachown , Martin F: <'&2%=:=? ;ote on !nterest .ate (arity and the $u""ly of ?rbitrage 3unds=, G%)%* :<, -o%3 =MayJGune?, pp% 025>05% 0euter <$%%3=: 62arling details #radford D #ingley bailout=,Monday, 19 September 155< SchwarF 9: <$%%&=:L-ind the 7a"< 2isentangling 'redit and 1i%uidity in .isk $"readsL, Aorking )aper, &olumbia /ni4ersity Kraduate School of usiness% Shadow Financial 0e!ulator )ommittees o" Asia, AustraliaB,ew Gealand, +urope, 4apan, 7atin America, and the #nited States <$%%2=:61essons from .ecent 3inancial Turmoil#, Goint Statement &openhagen =Denmark?, September ,5 Sohmen, +: <'&6'=: M3lexible Exchange .ates< Theory and 'ontroversy= &hicago: /ni4ersity of &hicago )ress% Stein, 4erome 7: <'&6$=: MThe ;ature and Efficiency of the 3oreign Exchange -arket=, *ssays in International Finance, no%25% )rinceton, -%G%: )rinceton /ni% )ress% Stoll, /:0: <'&2$=:L'auses of 2eviation from !nterest .ate (arityL, G% Money, &redit, Feb% ,9:1, 2, ,,3>,: Tapkin!, 4: and 8eller, B: <$%%3=:#0"en -arket 0"erations, 'entral #ank 'ollateral and the 2007R200> 1i%uidity Turmoil=, Mimeo, *uropean &entral ank Ta lor, 4: <$%%&=: 6The 3inancial 'risis and the (olicy .es"onses< ?n Em"irical ?nalysis of 8hat 8ent 8rong=,%- *+ Aorking )aper -o% ,283, Ta lor, 4ohn B: and 8illiams, 4ohn ): <$%%3a=: 6? #lack $wan in the -oney -arket=, Federal +eser4e ank of San Francisco, , (pril 155<, Aorking )aper 155<>52 Ta lor, 4ohn B: and 8illiams, 4ohn ): <$%%3b=: 63urther .esults on a #lack $wan in the -oney -arket=, Federal +eser4e ank of San Francisco, May 13, 155< anking,

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Ta lor, M: *: <'&32=: 6'overed interest "arity< a high-fre%uency, high-%uality data study= *conomica 02, 219>>3< Ta lor, M: *: <'&3&=: L'overed !nterest ?rbitrage and -arket TurbulenceL, *conomic Gournal 99: 3:8>39, Ta lor, 4ohn B: & 8illiams, 4ohn ): <$%%3=: 6? #lack $wan in the -oney -arket= Stanford /ni4ersity 7 Federal +eser4e ank of San Francisco, (pril 155<, Aorking )aper 155<>52 Thornton, -aniel 7: <$%%&=:M8hat the 1ibor-0!$ $"read $ays=, Daniel $% Thornton, Pice (resident and Economic ?dviser, 3ederal .eserve #ank of $t 1ouis, short essays and reports on the economic issues of the day, 1559, -umber 12 8ooldrid!e, * <$%%'=:6The emergence of new benchmark yield curves=, IS Wuarterly +e4iew, December, pp 2<V0:% 8u, Tao <$%%3=: 60n the Effectiveness of the 3ederal .eserve5s ;ew 1i%uidity 3acilities=, +esearch Department Aorking )aper 5<5< Federal +eser4e ank of Dallas )ublications: Press 'eleases& B,* *aribas <$%%2B*0=: 6#;( (aribas !nvestment (artners tem"oraly sus"ends the calculation of the ;et ?sset Palue of the following funds < (arvest 2ynamic ?#$, #;( (aribas ?#$ EF.!#0. and #;( (aribas ?#$ E0;!?= 9 (ugust 155: Bo) <$%%2a=: 6#ank of 'anada Tem"orarily Ex"ands 1ist of 'ollateral Eligible for $(.? Transactions=, ,0 (ugust 155: Bo) <$%%2b=: 6The #ank of 'anada5s Target for the 0vernight !nterest .ate (olicy !m"lementation 3ramework= Bo) <$%%2c=: 6#ank of 'anada welcomes initiatives to su""ort the functioning of financial markets in 'anada=, ,8 (ugust 155: Bo) <$%%2B*0c=: 6#ank of 'anada kee"s target for the overnight rate at G +R2 "er cent=, 0 September 155:, ank of &anada Bo) <$%%2B*0d=: 6#ank of 'anada lowers overnight rate target by +RG "ercentage "oint to G +RG "er cent=, 2 December 155:, ank of &anada Bo) <$%%3B*0lol=:6'entral #anks ?nnounce 'oordinated !nterest .ate .eductions=, < .ctober 155< Bo+ <$%%2=: 63inancial $tability .e"ort=, .ctober 155:, Issue -o% 11 Bo+ <$%%2aa=: 6#ank of England -arket ;otice< F$ 2ollar .e"o 0"erations=, ank of *ngland Bo+ <$%%3ab=: M$"ecial 1i%uidity $cheme< !nformation=,1, (pril 155< Bo+ <$%%3ac=: M$"ecial 1i%uidity $cheme< -arket ;otice=, 1, (pril 155< Bo+ <$%%3B*0lol=: 6#ank of England .educes #ank .ate by 0 / (ercentage (oints to G /S=, ank of *ngland, < .ctober 155<%
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Bo4 <$%%2B*0b=: 6?nnouncement of the -onetary (olicy -eeting 2ecisions=, ,9 September 155:, ank of Gapan% Bo4 <$%%3B*0lol=: 60n the (olicy ?ctions by -ajor 'entral #anks= < .ctober 155< )AFS <$%%3=: M&entral bank operations in response to the financial turmoil#, '73$ (a"ers -o 3,%, Guly 155<, &ommittee on the Klobal Financial System =&KFS?, ank of International Settlement% )AFS <$%%3B,o:('=: 6'entral bank o"erations in res"onse to the financial turmoil=, &KFS )apers -o 3,, Guly 155<, &ommittee on the Klobal Financial System, ank for International Settlements% -anmarks ,ationalbank <$%%2B(=: 6-onetary .eview ,rd Huarter=, ,2 September, 155:% +)B <$%%2B*0a =: M-onetary "olicy decisions=, 8 September 155:, *uropean &entral ank +)B <$%%2B*0oo=: 6-onetary "olicy and the money market< key "rinci"les and recent ex"erience= Speech by Gbrgen Stark, Member of the *Cecuti4e oard of the *& deli4ered at ayerischer anken4erband, Munich, ,0 -o4ember 155: +)B <$%%3B*0=: =-onetary "olicy decisions=, > 0ctober 200> +)B <$%%3B*0'5 1ct=: 6-easures to further ex"and the collateral framework and enhance the "rovision of li%uidity=, ,0 .ctober 155< +)B <$%%3B*0'3 -ec=:6Tender "rocedures and the standing facilities corridor as of 2+ Ianuary 2009=, ,< December 155< +)B <$%%3B*0e=: 6Tender (rocedure for the (rovision of F$ 2ollars to Eurosystem 'ounter"arties under the Term ?uction 3acility=, )ress +elease, 35 Guly 155<% +)B <$%%3B*0lol=: =-onetary "olicy decisions=, < .ctober 155< +uropean )ommission <$%%&=: 63unctional 2efinition of a 'entral 'ounter"arty 'learing 9ouse &''()=, 1< Guly 1559% +uropean )ommission <$%%&*0=: 629G>th 'ouncil -eeting Economic and 3inancial ?ffairs=, 9 Gune 1559, press release ,5:3:J59 F-I) <$%%3=:MI(-organ 'hase ?c%uires #anking 0"erations of 8ashington -utual=, 10 September 155<, Federal Deposit Insurance &orporation F+-B,? <$%%2k=: M$tatement .egarding .e"urchase ?greements 'overing Jear-End=, Federal +eser4e ank of -ew 6ork, -o4ember 18, 155:

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Federal 0eserve Bank o" ,ew ?ork <F0B,?= <$%%3=: MTreasury -arket (ractices 7rou" Endorses $everal -easures to ?ddress 8ides"read $ettlement 3ails=, (nnouncement, -o4ember ,1, 155<% Federal 0eserve S stem <$%%3lol=: 63ederal .eserve and other central banks announce reductions in "olicy interest rates=, < .ctober 155<, oard of Federal +eser4e System F+- <$%%3B*0a=: 6(ress .elease=, .ctober 1<, 155< F+- <$%%3B*0b=: 6(ress .elease=, .ctober 19, 155< F+- <$%%3B *0c=: 6(ress .elease=, Guly 35, 155< F+- <$%%3B*0"=: M)ress +elease#, ,8 September 155< F+- <$%%3B*0lok=: 62!$'0F;T ?;2 ?2P?;'E .?TE$ -- .e%uests by nine .eserve #anks to lower the "rimary credit rateK re%uests by three .eserve #anks to maintain the existing rate=, ,0 December 155< Federal 0eserve S stem <$%%2B&.th=: 69Gth ?nnual .e"ort=, oard of Ko4ernors of the Federal +eser4e System Federal 0eserve S stem <$%%277=: 63ederal .eserve ?ctions=, ,1 December 155:, oard of Federal +eser4e System Federal 0eserve S stem <$%%2mn=: 630-' $tatement=, September ,<, 155:, oard of Federal +eser4e System Federal 0eserve S stem <$%%2mo=: 630-' statement and #oard a""roval of discount rate re%uests of the 3ederal .eserve #anks of ;ew Jork, .ichmond, ?tlanta, 'hicago, $t 1ouis, and $an 3rancisco=, 3, .ctober 155:, oard of Federal +eser4e System Federal 0eserve S stem <$%%2mp=: 630-' statement and #oard a""roval of discount rate re%uests of the 3ederal .eserve #anks of ;ew Jork, (hiladel"hia, 'leveland, .ichmond, ?tlanta, 'hicago, and $t 1ouis=, ,, December 155:, oard of Federal +eser4e System Federal 0eserve S stem <$%%2mF=: 63ederal .eserve and other central banks announce measures designed to address elevated "ressures in short-term funding markets=, ,1 December 155:, oard of Federal +eser4e System Federal 0eserve S stem <$%%377=: 6(ress .elease=, ,8 March 155<, oard of Federal +eser4e System Federal 0eserve S stem <$%%3m;=: 630-' statement and #oard a""roval of discount rate re%uests of the 3ederal .eserve #anks of 'hicago and -innea"olis=, 11 Ganuary 155<, oard of Federal +eser4e System
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management Federal 0eserve S stem <$%%3mr=: 630-' statement and #oard a""roval of discount rate re%uests of the 3ederal .eserve #anks of #oston, ;ew Jork, (hiladel"hia, 'leveland, ?tlanta, 'hicago, $t 1ouis, *ansas 'ity, and $an 3rancisco=, 35 Ganuary 155<, oard of Federal +eser4e System Federal 0eserve S stem <$%%3ms=: 630-' statement and #oard a""roval of discount rate re%uests of the 3ederal .eserve #anks of ;ew Jork, 'leveland, ?tlanta, and $an 3rancisco=, 35 (pril 155<, oard of Federal +eser4e System Federal 0eserve S stem <$%%3mt=: 63ederal .eserve and other central banks announce s"ecific measures designed to address li%uidity "ressures in funding markets=, , March 155<, oard of Federal +eser4e System Financial Market StabiliFation Fund <SoFFin= <$%%&=: 6$o33in holds G7 ,+ "ercent of 9y"o .eal Estate 9olding ?7 &9.E)=, Frankfurt am Main, : May 1559 FSB <$%%&B*0=: M3inancial $tability #oard holds inaugural meeting in #asel#, Financial Stability oard, +ef no: 1<J1559, 1: Gune 1559 Aovernment o" ,etherlands <$%%3=: 6#enelux comes to aid of 3ortis=, 19 September 155< Mishkin <$%%2BS*=: 63inancial !nstability and -onetary (olicy=, Speech, Ko4ernor Frederic S% Mishkin, (t the +isk /S( 155: &onference, F*D, -ew 6ork, -ew 6ork -o4ember 0, 155: 0BA <$%%2a=: 62omestic -arket 2ealing ?rrangements=, 8 September 155:, +eser4e ank of (ustralia 0BA <$%%2B*0cc=: 6$tatement by 7lenn $tevens, 7overnor, -onetary (olicy=, < (ugust 155:, +eser4e ank of (ustralia 0BA <$%%2B*0cd=: 6$tatement by 7lenn $tevens, 7overnor, -onetary (olicy=, : -o4ember 155:, +eser4e ank of (ustralia 0BA <$%%3B*0cc=: 6$tatement by 7lenn $tevens, 7overnor, -onetary (olicy=, 0 February 155<, +eser4e ank of (ustralia 0iksbank <$%%2B*0a=: 6.e"o rate raised by 0 2/ "ercentage "oints to G "er cent=, 35 .ctober 155: 0iksbank <$%%2B*0b=: 6.e"o rate raised by 0 2/ "ercentage "oints to G 2/ "er cent=, ,3 February 155<% 0iksbank <$%%3B*0lol=: 6.e"o rate cut to G 2/ "er cent=, < .ctober 155<% S,B <$%%2aa=: 6$;# to ex"and its list of collateral eligible at the central bank=, ,2 (ugust 155:,

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management S,B <$%%2B*0cc=: 6-onetary "olicy assessment of +, 2ecember 2007=, Swiss -ational ank, !urich S,B <$%%2B*0cd=: 6-onetary "olicy assessment of +, $e"tember 2007, $;# aiming to calm the money market=, Swiss -ational ank, !urich S,B <$%%3B*0cc=: 6-onetary "olicy assessment of +, -arch 200>=, Swiss -ational ank, !urich S,B <$%%3B*0d=: M$wiss ;ational #ank to offer extended-term F$ dollar re"o o"erations=, )ress +elease, !urich 35 Guly 155<% S,B <$%%3B*0lol=: 6Ioint statement by central banks=< .ctober 155<, !brich Publications Basel 9omiteen <$%%%=: 6$ound (ractices for 1i%uidity .isk -anagement in #anking 0rganisations=, IS BBA <$%%&=: 6##? 1!#0.=, Gohn *wan, Director% BIS <'&3(=: 6The !nternational !nterbank -arket- ? 2escri"tive $tudy=, Monetary and *conomic Department asle, *conomic )apers, -o% <, Guly ,9<3, p%,>22 BIS <'&&&a=: 6-arket 1i%uidity< .esearch 3indings and $elected (olicy !m"lications =&ommittee on the Klobal Financial System )ublications -o% ,, BIS <'&&&b=: 6(rinci"les for the -anagement of 'redit .isk= &onsultati4e paper issued by the asel &ommittee on anking Super4ision !ssued for comment by ,0 ;ovember +999 asel BIS <$%%(=: 6#asel !!< The ;ew #asel 'a"ital ?ccord=, Third &onsultati4e )aper =ok? BIS <$%%2n=: MTriennial 'entral #ank $urvey< 3oreign Exchange and 2erivatives -arket ?ctivity in 2007=, December% BIS <$%%2t=: 6!nternational money market disru"tions, central bank reactions and lessons learnt= Introductory remarks by Mr% Thomas Gordan, Member of the Ko4erning oard of the Swiss -ational ank, at the end>of>year media news conference, !urich, ,3 December 155:% BIS <$%%3=: L.atings in structured finance< what went wrong and what can be done to address shortcomings:= &KFS )apers -o 31% BIS <$%%3d=: 60verview< global financial crisis s"urs un"recedented "olicy actions=, IS Wuarterly +e4iew, December BISB,o:(' <$%%3=:='entral #ank 0"erations in res"onse to the financial Turmoil#, &ommittee on the Klobal Financial System =&KFS? )apers -o%3,, Guly% BIS <$%%&abc=: 679th ?nnual .e"ort=,, (pril 155<V 3, March 1559, asel, 19 Gune 1559

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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management BIS Huarterl 0eview <$%%&BMarch=: 6!nternational banking and financial market develo"ments=, March 1559 Bo+ <$%%3BAnne>=: 63inancial $tability .eview=, Issue 12, ank of *ngland, (nneC -anmarks ,ationalbank <$%%(=: 63inansiel styring ! 2anmarks ;ationalbank=, ,%udga4e, 2%opslag% -anmarks ,ationalbank <$%%.=: 6#odil ;yboe ?ndersens tale "Q 3inansrQdets QrsmTde= -anmarks ,ationalbank <$%%3B'=: 6+ Huarter -onetary .eview= +)B <$%%2=: 3inancial $tability .eview, December, *uropean &entral ank +)B <$%%3=: 63inancial $tability .eview= =Gune?, *uropean &entral ank% +)B <$%%3t=: 6The !m"lementation of -onetary "olicy in the Euro ?rea=, Keneral Documentation on *urosystem Monetary )olicy Instruments and )rocedure, -o4ember 155<% +)B < $%%&=: 63inancial $tability .eview= =Gune?% +)B <$%%&mm=: 6Euro -oney -arket $tudy 200>=, February 1559, *uropean &entral ank% Fed <$%%&BM0=: 6'redit and 1i%uidity (rograms and the #alance $heet= Federal +eser4e System Monthly +eport, (ugust 1559 Federal 0eserve Bank o" ,ew ?ork <$%%2=: 6Treasury and 3ederal .eserve exchange o"erations< Iuly-$e"tember 2007=, -o4ember% F+-B,? <$%%'=: M$0-? $ecurities 1ending (rogram Terms and 'onditions &.evised)=, *ffecti4e .ctober ,<, 155,, Federal +eser4e ank of -ew 6ork Fitch 0atin! <$%%2=: 6!nside the .atings< 8hat 'redit .atings -eans=, (ugust Fitch 0atin!s <$%%&a=: 6$overeigns< Euro"ean government borrowing=, International Special +eport, 18 Ganuary% Fitch 0atin!s <$%%&b=: 62efinitions of .atings and 0ther $cales=, March IMF <$%%3c=: 6-arket and 3unding !lli%uidity< 8hen (rivate .isk #ecomes (ublic=, Klobal Financial Stability +eport =KFS+?, (pril 155<, p%<8>,,: IMF <$%%3BApr=: 67lobal 3inancial $tability .e"ort, 'ontaining $ystemic .isk and .estoring 3inancial $oundness=, Aorld *conomic and Financial Sur4eys, International Monetary Fund Aashington D& IMF <$%%3=: 67lobal 3inancial $tability .e"ort, 'ontaining $ystemic .isks and .estoring 3inancial $oundness=, Aorld *conomic and Financial Sur4eys, (pril155< IMF <$%%&=: 67lobal 3inancial $tability .e"ort .es"onding to the 3inancial 'risis and -easuring $ystemic .isks=, Aorld *conomic and Financial Sur4eys, (pril 1559, Aashington D&%
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Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management IMF <$%%&B#pdate=: 67lobal 3inancial $tability .e"ort @-arket F"date=, Monetary and &apital Market Department, Guly 1559% 4:*: Mor!an: 'redit-etrics @ 6Technical 2ocument#, ,99:, G%)% Morgan 1+)- <$%%2=:= 7lossary of $tatistically Terms= .rganisation for *conomic &o>operation and De4elopment% S,B <$%%&=: 63inancial $tability .e"ort=, Swiss -ational ank S,B <$%%&BAppendi>=: 6.esults of the F$ dollar auctions=, Swiss -ational ank Standard & *oor <$%%&=: 6$tandard D (oorMs .atings 2efinitions= (pril 35% 8orld Bank <$%%3=: 67lobal 2evelo"ment 3inance 200>, the .ole of !nternational #anking=, I: +e4iew, (nalysis, and .utlook% 9ebsites& Standard & *oorKs: http:JJwww%standardandpoors%com Mood Ls Investors Service: htt"<RRwww%moodys%com Fitch: htt"<RRwww%fitch%com #9 Aovernment: htt"<RRwww%direct%go4%uk -ie Bundesre!ierun!: htt"<RRwww%bundesregierung%de The #:S: AovernmentKs 1""icial 8eb *ortal: htt"<RRwww%usa%go4 British Bankers Association: http:JJwww%bbalibor%comJbbaJHspJpolopoly%HspIdT,883, Date: 1: Guly 1559 +uropean Bakin! Federation: http:JJwww%fbe%beJ&ontentJDefault%asp, http:JJebf%irisb1b%comJ&ontentsJ&ontents%asp, Date: 1: Guly 1559% International Swaps and -erivatives Association: http:JJwww%isda%orgJ +urepo: http:JJwww%eurepo%orgJ bbaliborM: http:JJwww%bbalibor%comJbbaJHspJpolopoly%HspIdT,81,

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