Segmented money markets and covered interest parity arbitrage

Dagfinn Rime, Andreas Schrimpf and Olav Syrstad

No 651, BIS Working Papers from Bank for International Settlements

Abstract: This paper studies the violation of the most basic no-arbitrage condition in international finance - Covered Interest Parity (CIP). To understand the CIP conundrum, it is key to (i) account for funding frictions in U.S. dollar money markets, and (ii) to study the challenges of swap intermediaries when funding liquidity evolves differently across major currency areas. We find that CIP holds remarkably well for most potential arbitrageurs when applying their marginal funding rates. With severe funding liquidity differences, however, it becomes impossible for dealers 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. We show how a situation with persistent arbitrage profits arises 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: 81 pages
Date: 2017-07
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (57)

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Related works:
Working Paper: Segmented money markets and covered interest parity arbitrage (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:bis:biswps:651

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