Segmented money markets and covered interest parity arbitrage

Dagfinn Rime, Andreas Schrimpf and Olav Syrstad
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Olav Syrstad: Norges Bank (Central Bank of Norway)

No 2017/15, Working Paper from Norges Bank

Abstract: This paper studies the violation of the most basic no-arbitrage condition in international finance — Covered Interest Parity (CIP). We find that the CIP puzzle largely stems from funding liquidity differences, reflected in the marginal funding rates of the main arbitrageurs. With severe funding liquidity differences, it becomes impossible for FX swap intermediaries to quote prices such that CIP holds across the full rate spectrum. A narrow set of global top-tier banks enjoys risk-less arbitrage opportunities as dealers set quotes to avert order flow imbalances. A situation with persistent arbitrage opportunities emerges as an equilibrium outcome due to the constellation of market segmentation, the abundance of excess reserves and their remuneration in central banks’ deposit facilities.

Keywords: Covered Interest Parity; Money Market Segmentation; Funding Liquidity Premia; FX Swap Market; U.S. Dollar Funding (search for similar items in EconPapers)
JEL-codes: E43 F31 G15 (search for similar items in EconPapers)
Pages: 71 pages
Date: 2017-09-06
New Economics Papers: this item is included in nep-mac and nep-mon
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Citations: View citations in EconPapers (54)

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Working Paper: Segmented money markets and covered interest parity arbitrage (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:bno:worpap:2017_15

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