The microstructure of covered interest arbitrage in a market with a dominant market maker

Hao-Chen Liu and Mark Witte

Journal of International Financial Markets, Institutions and Money, 2013, vol. 24, issue C, 25-41

Abstract: Measured by transaction volume, foreign exchange swaps are the largest market in the world. However, there are very few empirical studies of swap rates. Theoretically, covered interest parity is commonly assumed. But what factors determine arbitrage opportunities? We create a unique microstructure model of exchange rate activity to identify theoretical predictions regarding covered interest arbitrage in a market with a dominant market maker. Using a unique data set of actual, recorded swap transactions, not price quotes, the model is verified as we find economically significant returns that depend in part on market volatility, contract irregularity and trader identity.

Keywords: Exchange rates; Covered interest; Foreign exchange microstructure; Forward swap; Hedging (search for similar items in EconPapers)
JEL-codes: F31 F41 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:intfin:v:24:y:2013:i:c:p:25-41

DOI: 10.1016/j.intfin.2012.11.012

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