Covered Interest Arbitrage and Market Turbulence

Mark Taylor

Economic Journal, 1989, vol. 99, issue 396, 376-91

Abstract: The covered interest parity theorem states that the covered interest differential between two similar assets denominated in different currencies should be zero. This paper utilizes high-quality data recorded by the dealers at the Bank of England to test covered interest parity during certain historical periods in which there is known to have been turbulence, as well as during a relatively calm, control period. The data is high-frequency and allowance is made for the bid-offer spread, brokerage costs, and other considerations. The results have three main implications. Firstly, profitable arbitrage opportunities do occasionally occur and sometimes persist during turbulent periods. Secondly, the degree of efficiency of the relevant markets appears to have increased over time. Thirdly, there appears to be a "maturity effect" whereby the existence and size of profitable arbitrage opportunities appear to be positive functions of the length of maturity. A rationalization of this phenomenon is offered in terms of the existence of credit limits. Copyright 1989 by Royal Economic Society.

Date: 1989
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