Cross-Border Finance: FX Markets, Covered Interest Parity Deviations, and Currency Risk

Abstract

Foreign exchange (FX) markets—the largest financial markets globally with daily trading volume exceeding $7.5 trillion—determine the relative prices of currencies and transmit financial conditions across borders. Covered Interest Parity (CIP)—the arbitrage relationship that equates the forward premium/discount on a currency with the interest rate differential between two currencies—was considered one of finance’s most robust no-arbitrage conditions until Du, Tepper, and Verdelhan (2018) in the Journal of Finance documented persistent and economically large CIP deviations following the 2008 financial crisis, attributing them to balance sheet constraints on major bank arbitrage activity. The uncovered carry trade—borrowing low-interest-rate currencies to invest in high-interest-rate currencies—violates uncovered interest parity (which predicts that interest differentials equal expected depreciation) and has historically generated positive returns but with severe crash risk. This paper reviews FX market structure, CIP and its post-crisis deviations, the carry trade’s risk and return, and currency risk’s role in international portfolio management.