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2011 Feb/01
Analysis of the cause of persistent deviation of interest rate parity condition in the Korean swap market and its effect on the won-dollar foreign exchange market
Research Papers 11-02
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- Research Topic Capital Markets
이윤재
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- Summary
- The global financial crisis of 2008 caused persistent deviation of the covered interest rate parity condition in the major currency swap markets. The deviation was far worse in the Korean foreign currency money market with widening of swap basis to a historical level, reflecting the rapid depletion of liquidity in the market. The won-dollar foreign exchange market was also affected with precipitous depreciation of the Korean won accompanied by significant volatility increase. The spread between the LIBOR and the Overnight Index Swap, and the Korean CDS premium significantly affected the disparity in the market, reflecting the role played by the heightened liquidity and credit risk conditions both in and out of the Korean domestic market. From a microstructural point of view, a significant drop in the volume of transaction in the foreign exchange market can cause market distortion in terms of certain concentration of information and influence among the broker-dealers and also vis-a-vis the end-users causing information asymmetry which may result in overshooting of both the level and volatility of the currency. A GARCH(1,1) was used to test this hypothesis and revealed the significance of the market pressure and information asymmetry in explaining the rate of changes of the won-dollar exchange rate.