Covered interest parity deviation and counterparty default risk: U.S. Dollar/Korean Won FX swap market

We investigate how much of the observed CIP (covered interest parity) deviation in the U.S. Dollar/Korean Won FX (foreign exchange) swap markets during the financial crisis can be explained by credit risk. To this end, we develop a structural model of defaultable FX swaps, applying the approach of Coval et al. (2009a, 2009b) to the FX setting. Calibrating the model to Korean banks and U.S. banks, we find that significant portions of the CIP deviation in the U.S. Dollar/Korean Won FX swaps can be explained by counterparty risk; most of this effect is due to the counterparty risk of Korean banks (as opposed to U.S. banks). The influence of counterparty default risk is pronounced particularly for the period after the default of Lehman Brothers.