Covered Interest Parity Arbitrage

Abstract

To understand deviations from Covered Interest Parity (CIP) it is crucial to account for heterogeneity in funding costs---both across 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. In equilibrium, dealers avert inventory imbalances coming from lower-rated banks using the FX swap market to cover demand for 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 Risk Premia, FX Swap Market, US Dollar Funding

JEL Classification: E43, F31, G15