Covered Interest Parity Arbitrage

Review of Financial Studies (forthcoming)

116 Pages Posted: 5 Dec 2016 Last revised: 11 Jan 2022

See all articles by Dagfinn Rime

Dagfinn Rime

BI Norwegian Business School

Andreas Schrimpf

CREATES - Aarhus University; Bank for International Settlements (BIS) - Monetary and Economic Department

Olav Syrstad

Norges Bank

Multiple version iconThere are 4 versions of this paper

Date Written: December 15, 2021

Abstract

To understand deviations from Covered Interest Parity (CIP) it is crucial to account for heterogeneity in funding costs---across both banks and currency areas. For most market participants, the no-arbitrage relation holds fairly well when implemented using marginal funding costs and risk-free investment instruments. However, a few high-rated banks do enjoy CIP-arbitrage opportunities. Dealers avert inventory imbalances stemming from lower-rated banks' usage of FX swaps to obtain dollar funding, by inducing opposite (arbitrage) flows from high-rated banks. Arbitrage trades are difficult to scale, however, because funding costs increase as soon as arbitrageurs increase positions.

Keywords: Covered interest parity; Money market segmentation; Funding liquidity; FX swap market; U.S. dollar funding

JEL Classification: E43, F31, G15

Suggested Citation

Rime, Dagfinn and Schrimpf, Andreas and Schrimpf, Andreas and Syrstad, Olav, Covered Interest Parity Arbitrage (December 15, 2021). Review of Financial Studies (forthcoming), Available at SSRN: https://ssrn.com/abstract=2879904 or http://dx.doi.org/10.2139/ssrn.2879904

Dagfinn Rime (Contact Author)

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway
+47-46410507 (Phone)

HOME PAGE: http://home.bi.no/dagfinn.rime/

Andreas Schrimpf

CREATES - Aarhus University ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Olav Syrstad

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

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