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Segmented Money Markets and Covered Interest Parity Arbitrage

77 Pages Posted: 5 Dec 2016 Last revised: 11 Sep 2017

Dagfinn Rime

BI Norwegian Business School

Andreas Schrimpf

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

Olav Syrstad

Norges Bank

Multiple version iconThere are 2 versions of this paper

Date Written: August 31, 2017

Abstract

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

Rime, Dagfinn and Schrimpf, Andreas and Syrstad, Olav, Segmented Money Markets and Covered Interest Parity Arbitrage (August 31, 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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