Covered Interest Rate Parity Deviations in External Emerging Market Sovereign Debt

Abstract

Non-US dollar denominated external emerging market debt issuance in euros, yen, and sterling has grown substantially in recent years. This article is the first study to explore how non-dollar external emerging market bonds violate covered interest rate parity relative to their dollar-denominated external emerging market debt counterpart bonds for a given country. Such mispricing in the post-Great Recession era creates arbitrage opportunities for investors and suggests that emerging market country policymakers could create fiscal savings by instead issuing external sovereign debt in dollars more cheaply (versus non-dollar developed world currencies like euro, yen, and sterling) and swapping the proceeds to non-dollar currencies with currency forward and spot transactions. Such hypothetical fiscal savings from switching to dollar funding collectively are estimated to be more than $1 billion annually.

TOPICS: Fixed income and structured finance, exchanges/markets/clearinghouses, emerging markets

Key Findings

• • This article is the first study to explore how non-dollar external emerging market bonds violate covered interest rate parity relative to their dollar-denominated external emerging market debt counterpart bonds for a given country.

• • Such mispricing creates investment opportunities and suggests that by instead more cheaply issuing external sovereign debt in dollars (versus non-dollar developed world currencies like euro, yen, and sterling) and swapping the proceeds to non-dollar currencies, emerging market country policymakers could create substantial fiscal savings from switching to dollar funding.