Limits to Arbitrage during the Crisis: Finding Liquidity Constraints and Covered Interest Parity

Tommaso Mancini Griffoli () and Angelo Ranaldo

No 1212, Working Papers on Finance from University of St. Gallen, School of Finance

Abstract: Arbitrage ensures that covered interest parity holds. The condition is central to price foreign exchange forwards and interbank lending rates, and reflects the efficient functioning of markets. Normally, deviations from arbitrage, if any, last seconds and reach a few basis points. But after the Lehman bankruptcy, arbitrage broke down. By replicating exactly two major arbitrage strategies and using high frequency prices from novel datasets, this paper shows that arbitrage profits were large, persisted for months and involved borrowing in dollars. Empirical analysis suggests that insufficient funding liquidity in dollars kept traders from arbitraging away excess profits.

Keywords: limits to arbitrage; covered interest parity; funding liquidity; financial crisis; slow moving capital; market freeze; unconventional monetary policy. (search for similar items in EconPapers)
JEL-codes: F31 G01 G14 (search for similar items in EconPapers)
Pages: 46 pages
Date: 2012-11
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (16)

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http://ux-tauri.unisg.ch/RePEc/usg/sfwpfi/WPF-1212.pdf (application/pdf)

Related works:
Working Paper: Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:usg:sfwpfi:2012:12

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