Limits to Arbitrage and Deviations from Covered Interest Rate Parity

James Pinnington and Maral Shamloo

Discussion Papers from Bank of Canada

Abstract: We document an increase in deviations from short-term covered interest rate parity (CIP) in the first half of 2015. Since the Swiss National Bank’s (SNB) decision to abandon its minimum exchange rate policy, both the magnitude and volatility of deviations from CIP have increased across several currency pairs. The effect is particularly pronounced for pairs involving the Swiss franc. These deviations are distinct from those observed during the financial crisis. We argue that they are a consequence of reduced liquidity in foreign exchange markets, rather than imbalances in international funding markets. A reduction in the supply of forward contracts, owing to limited dealer capacity following the SNB decision, led to wide bid-ask spreads in the forward market. This friction, pertaining specifically to the foreign exchange market rather than broader funding markets, allowed deviations from CIP to persist.

Keywords: Exchange rates; International financial markets (search for similar items in EconPapers)
JEL-codes: F31 G15 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2016
New Economics Papers: this item is included in nep-mon and nep-opm
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Citations: View citations in EconPapers (19)

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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocadp:16-4

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