During the global financial turmoil in 2007-2008, deviation from the covered interest parity (CIP) between the Korean won and US dollar through the foreign exchange swap has escalated in its magnitude beyond 1,000bp in November 2008, and it still persists around 100bp level. In this paper, we examine a newly developed margin based asset pricing model using the Kalman filter approach and show that the escalation of the CIP deviations is found to be significantly related to the global dollar funding illiquidity and country-specific funding conditions. Furthermore, we find evidence that the poor funding conditions (or higher margins) are driven by the general money market illiquidity and may lead to higher funding illiquidity, which suggests the reinforcing effects of the liquidity spiral. We also show that the supply of dollar liquidity and improved funding conditions help alleviate the deviations from the parity, however the persistent anomaly is found to be related to the high level of exchange rate volatility.

Summary

Chapter 1. Introduction

Chapter 2. Theoretical Framework
　1. A Margin Based Asset Pricing Model
　2. Testable Implication on the CIP Deviation

Chapter 3. Econometric Methodology
　1. Discrete Approximation to the Continuous-time Asset Pricing Equation
　2. Nonlinear State Space Model in a Logistic Form

Chapter 4. Empirical Analysis
　1. Data
　2. CIP Deviation and Relative Margin
　3. Does Market Illiquidity Affect Margin?

Chapter 5. Conclusion

References