Segmented Money Markets and Covered Interest Parity Arbitrage

78 Pages Posted: 5 Dec 2016 Last revised: 8 May 2017

Dagfinn Rime

BI Norwegian Business School

Andreas Schrimpf

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

Olav Syrstad

Norges Bank

Date Written: May 8, 2017

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 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

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

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

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