78 Pages Posted: 5 Dec 2016 Last revised: 8 May 2017
Date Written: May 8, 2017
This paper studies the validity of Covered Interest Parity (CIP) -- once seen as the most robust no-arbitrage relationship in international finance, but now deemed broken. We argue that to understand the CIP puzzle, it is important to account for the marginal funding costs faced by the critical arbitrageurs, and to study the challenge of FX swap market intermediaries in balancing order flow. We find that CIP in fact holds remarkably well when considering money market rates reflecting funding liquidity premia. While arbitrage profits are very difficult to reap for the vast majority of players, a narrow set of banks does indeed face risk-less CIP arbitrage opportunities. Segmentation and funding strains in U.S. dollar money markets are the main forces that limit arbitrage activity. We show how such a situation arises as an equilibrium outcome due to the constellation of money market segmentation in U.S. dollar markets, the abundance of excess reserves and their remuneration in central banks' deposit facilities.
Keywords: Covered Interest Parity, Money Market Segmentation, Funding Liquidity Risk Premia, FX Swap Market, US Dollar Funding
JEL Classification: E43, F31, G15
Suggested Citation: Suggested Citation
Rime, Dagfinn and Schrimpf, Andreas and Syrstad, Olav, Segmented Money Markets and Covered Interest Parity Arbitrage (May 8, 2017). Available at SSRN: https://ssrn.com/abstract=2879904