Covered Interest Parity Arbitrage
Review of Financial Studies (forthcoming)
116 Pages Posted: 5 Dec 2016 Last revised: 11 Jan 2022
Date Written: December 15, 2021
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: Suggested Citation