Description:
This study examines the failure of covered interest parity (CIP) in long-term cross-currency basis swap (CCBS) markets. We conjecture that frictions in corporate bond markets urge firms to raise funds in one market and enter a CCBS contract to exchange the debt in a different currency. Therefore, frictions in the corporate bond market explain the failure of CIP in the long-term CCBS market. We illustrate this idea using a simple theoretical model and then explore the determinants of CCBS spreads and demonstrate the links between corporate funding needs and the long-term CCBS market. We show that frictions (illiquidity in the banking sector) and credit risk are essential drivers of CCBS spreads during economic stress