The validity of the covered interest rate parity is analyzed under an environment 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. To do so, this paper presents a simple model that incorporates the market structure of government bond and cross-currency swap markets, and bargaining between domestic and foreign banks. The bargaining solution represents an equilibrium relationship between the government bond and cross-currency swap rates. Foreign banks' profit/surplus maximization, given the bargaining solution, generates equilibrium foreign inflows, government bond and cross-currency swap rates in the model. This paper proves that the covered interest rate parity does not hold in monopolistic or oligopolistic environments. Furthermore, this paper illustrates some comparative statics results, which may be interesting to policy makers, including the responses of equilibrium foreign inflows, government bond and cross-currency swap rates with respect to adjustments of the policy rate. This paper also traces out how these comparative statics change in magnitude as the markets are populated by more and more foreign banks so that the markets become more and more competitive. This paper shows that the equilibrium government bond and cross-currency swap rates approach the condition imposed by covered interest rate parity as the markets get more competitive, and indeed in the limit, i.e. in perfect competition, the covered interest rate parity holds under some conditions.

KeyWords: monopoly, oligopoly, market structure, market power, cross-currency swap market, bargaining, covered interest rate parity

JEL Classication: F31, F32, G12, G15.


1 Introduction 1
2 Model 4
3 Individual Rationality Conditions and Bargaining Solutions 7
4 Analysis of Monopoly Case 10
5 Extension to Oligopoly Cases 20
6 Conclusion 30