Explanation:
Both statements correctly explain the post-GFC violations of Covered Interest Rate Parity (CIRP), as detailed in the literature such as Borio's "Covered interest parity lost: understanding the cross-currency basis".
I. Hedging demand imbalances: A structural demand for currency hedges exists among banks, institutional investors, and non-financial firms (e.g., closing balance sheet mismatches, hedging foreign currency asset exposures). This persistent one-sided demand puts pressure on forward exchange rates, causing the basis to widen. II. Limits to arbitrage / Balance sheet costs: Pre-GFC, it was assumed arbitrageurs would effortlessly step in to close any CIRP pricing gaps. Post-GFC regulations (such as stricter capital requirements and leverage ratio constraints) made balance sheet space scarce and costly. Arbitrageurs now price in these frictional costs, preventing them from fully arbitraging away the basis, allowing CIRP violations to persist.
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I. The basis tends to open up because banks, institutional investors, and non-financial firms tend to demand currency hedges; e.g., banks tend to close balance sheet currency mismatches with FX swaps
II. Although academic arbitrage tends to ignore frictional costs, since the GFC participants tend to price the costs and hidden risks of arbitrage; e.g., arbitrage enlarges the balance sheet
Which statement(s) by Patricia explain the violation(s) of CIRP since the GFC?
A
a) Neither I. nor II.
B
b) Only I.
C
c) Only II.
D
d) Both I. and II.