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Covered Interest Rate Parity: A Model of Cournot Competition and Bargaining with Outside Option(Working Paper)

Economic Research Institute (82-2-759-5485) 2009.09.02 1003
This paper extends the author's previous paper (2009) and examines the valid-
ity of the covered interest rate parity in a theoretical perspective. The previous
paper analyzed the validity of the covered interest rate parity under an envi-
ronment in which foreign banks exercise market power in the government bond
and the cross-currency swap markets and bargain with domestic banks over the
surplus, and showed that the equilibrium government bond and cross-currency
swap rates approach the condition imposed by covered interest rate parity as the
markets are populated by more and more foreign banks. In this paper, domestic
banks' comparative advantage and disadvantage over foreign banks are explicitly
considered: domestic banks can borrow in foreign currency by accessing the inter-
national nancial market directly at a rate with some premium and can generate
higher rate of return on investments in domestic currency. The existence of out-
side option changes the bargaining solution between domestic and foreign banks
drastically and, in turn, the validity of the covered interest rate parity. It turns
out that the market structure and the timing of events are crucial. In particular,
this paper proves that if the bargaining takes place before the forward contracts,
not only in nite number of foreign banks but also in nite number of domestic
banks is in need for the covered interest rate parity to hold. On the other hand, if
the bargaining takes place after the forward contracts, a new form of equilibrium
condition, which is totally di erent from the conventional covered interest rate
parity, emerges even in perfectly competitive environment. This paper illustrates
comparative statics as well.

1 Introduction

2 Model

3 Individual Rationality Conditions and Bargaining Solution

4 Analysis of Oligopoly Cases

5 A New Form of Covered Interest Rate Parity

6 Conclusion