Segmented Money Markets and Covered Interest Parity Arbitrage

66 Pages Posted: 5 Dec 2016  

Dagfinn Rime

BI Norwegian Business School

Andreas Schrimpf

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

Olav Syrstad

Norges Bank

Date Written: December 3, 2016

Abstract

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 it is crucial to account for the effects of money market segmentation and funding liquidity premia, especially in the post-crisis environment characterized by a significant dispersion of money market rates. We find that CIP in fact holds remarkably well when considering money market rates that adequately capture funding liquidity premia. Our approach informs about the forces that effectively limit arbitrage activity in FX swaps and money markets. While arbitrage opportunities are difficult to reap for the vast majority of players, a narrow set of banks does indeed face risk-less arbitrage opportunities. These arise from the constellation of money market segmentation, 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

Rime, Dagfinn and Schrimpf, Andreas and Syrstad, Olav, Segmented Money Markets and Covered Interest Parity Arbitrage (December 3, 2016). Available at SSRN: https://ssrn.com/abstract=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

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

Paper statistics

Downloads
347
Rank
68,556
Abstract Views
1,051