# LO 77.2: Explain the effects of forced deleveraging and the failure of covered

LO 77.2: Explain the effects of forced deleveraging and the failure of covered interest rate parity.
Effects of Forced Deleveraging
Forced deleveraging refers to the reduction in leverage by a borrower following capital market events that necessitate deleveraging. A good gauge of leverage is the haircut in the repurchase agreement (repo) market. The haircut refers to the difference between the value of the collateral pledged and the amount borrowed. For example, a 2% haircut implies that a bank is able to borrow $98 dollars for every$100 in securities pledged. The lower
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the haircut, the higher the leverage implied in the transaction. The 2% haircut implies a leverage factor (or leverage ratio) of 50 for the bank (computed as total assets over equity).
Prior to the financial crisis of 20072009, leverage factors of 50 were not uncommon, with corresponding very low haircut values. However, such high leverage left many banks exposed to potential forced deleveraging. Indeed, in the period immediately following the financial crisis, the leverage factor dropped to around 25 in the U.S. securities broker-dealer sector, with the haircut increasing from 2% to 4%. In general, such a large change has material consequences. Assuming a banks equity isnt impacted, the bank would have to cut its assets in half. If the bank also suffers losses, the impact is even worse.
VIX as a Gauge of Leverage
Up until the onset of the financial crisis, the volatility index (VIX) represented a good gauge of the appetite for leverage in the markets. The VIX measures implied volatility from stock option (call and put) prices. Prior to the financial crisis, a low VIX implied low fear and therefore high leverage. The VIX was able to adequately capture the risk appetite within the financial system. Given that banks typically borrow in order to lend funds, easy conditions for borrowing also created easy conditions for lending, creating a circular series of events that led to ever easier borrowing and liquidity as well as higher leverage.
However, the VIX as a reliable gauge of leverage shifted dramatically following the financial crisis. The previous relationships of high VIX-low leverage / low VIX-high leverage ceased to hold and the VIX lost its explanatory power of leverage. While there remains considerable risk appetite for stocks, as witnessed by high stock valuations and low volatility, the banking sector has not fared comparatively well, with low market-to-book value ratios.
So what has changed? One explanation is that monetary easing has calmed markets and compressed credit spreads, although this explanation generally holds best when policy rates are positive. Another explanation could be the role of regulation, which impacts bank behavior and may constrain leverage. A counterargument to the role of regulation is that the financial crisis was not brought on by regulatory change (although regulatory change certainly followed in the post-crisis period). Capitalization also plays a role in the financial health of the banking sector. Better capitalized banks weathered the crisis better and have fared well compared to their weaker capitalized counterparts.
Failure of Covered Interest Arbitrage
Covered interest parity (CIP) is a parity condition that states that the interest rates implied in foreign exchange markets should be consistent with the money market rate for each currency. In other words, the interest rate implied between the forward and spot rates on a U.S. dollar forward or swap (one side borrows U.S. dollars and lends another currency) should be the same as the money market interest on the dollar. If the relationship does not hold, an arbitrage opportunity would exist for earning a profit on borrowing cheap in one currency, lending out funds at a higher rate in another currency, and concurrently fully hedging currency risk.
CIP held up reasonably well before the financial crisis. However, the relationship no longer worked well in the post-crisis period, and a gap between CIP-implied rates and observed
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rates has persisted. The primary reason for the difference is that CIP is a theoretical concept based on certain simplifying assumptions, including the ability to take on any position in any currency at prevailing market prices. In reality, borrowers and lenders need to transact through banks, which may not have sufficient capital to enter into these transactions or may find the spreads to be uneconomical. Capital may be insufficient partly due to regulation, although banks typically have capital well above regulatory requirements.
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