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ABSTRACT
We develop a model that shows that the Eurocurrency market risk premium is comprised of two components: sovereign risk and credit risk. On the basis of our model, we construct hypotheses that explain the differences in risk both within and across Eurocurrency trading centers. We use daily LIBOR, SIBOR, and TIBOR benchmark rates for several Eurocurrencies to empirically test the hypotheses. Our inter-market test results indicate a strong positive relationship between pairs of risk premia. Differences in inter-market risk premia are explained by differences in: sovereign risk between host countries, and Eurobank credit quality. Our intra-market tests show a weak positive relationship between pairs of risk premia. Differences in intra-market risk premia are explained by differences in: sovereign risk between the countries issuing the underlying currencies, Eurobank credit quality, and domestic bank credit quality.
JEL Classification: E43, F34, G21
Keywords: Eurocurrency market; Risk premium; Sovereign risk; Credit risk
I. INTRODUCTION
The difference between the offshore Eurocurrency deposit rate and domestic onshore deposit rate for the same currency is frequently positive. Eurobanks, however, are not required to provide deposit insurance or hold reserves against deposits. Consequently, it is frequently argued, they operate at a relative cost advantage to domestic banks, and can thus offer a higher deposit rate to the depositor. Risk differences are less frequently cited as the reason for the difference between offshore and onshore deposit rates. Sovereign risk is always present in offshore deposits and a difference in bank credit quality between offshore and onshore banks may also exist.
Firstly, given common risks and costs, the "law of one price" suggests that all offshore trading centers will offer identical deposit rates for the same Eurocurrency. When this is the case, their risk premia will obviously be identical. Secondly, if one ignores offshore deposit risk and assumes an equal cost advantage in acquiring offshore deposits, the difference between Eurocurrency rates for two different currencies traded within a single Eurocurrency trading center must logically be explainable by the Fisher effect, i.e., a difference in expected inflation rates between the two home countries whose currencies denominate the offshore deposits.
In fact, the pricing convention in the interest rate and currency swap markets ignores intra-market risk differences between Eurocurrencies. For example, the floating leg...