Segmented Money Markets and Covered Interest Parity Arbitrage
77 Pages Posted: 5 Dec 2016 Last revised: 11 Sep 2017
Date Written: August 31, 2017
This paper studies the violation of the most basic no-arbitrage condition in international finance --- Covered Interest Parity (CIP). We find that the CIP puzzle largely stems from funding liquidity differences, reflected in the marginal funding rates of the main arbitrageurs. With severe funding liquidity differences, it becomes impossible for FX swap intermediaries to quote prices such that CIP holds across the full rate spectrum. A narrow set of global top-tier banks enjoys risk-less arbitrage opportunities as dealers set quotes to avert order flow imbalances. A situation with persistent arbitrage opportunities emerges as an equilibrium outcome due to the constellation of 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: Suggested Citation