Covered Interest Parity in long-dated securities

Abstract

This paper investigates the validity of Covered Interest Rate Parity (CIP) in long-dated fixed income securities. I show that common measures of CIP in securities of longer maturities rely on trading strategies subject to rollover risk and credit risk, or fail to fully account for the trading costs. Hence, round-trip CIP profit is generally not possible to reap when the trade is risk-free and all costs are taken into account. In particular, short-selling costs (haircuts and lending fees) and differences in funding spreads across currencies allow for substantial deviations from CIP without implying arbitrage opportunities. In contrast to recent research, my results suggest that CIP holds well and lend little support to the view that stricter banking regulations have led to persistent arbitrage opportunities in long-dated fixed income and currency markets.

Keywords: Covered Interest Parity, FX-swaps, Libor, Corporate bonds, Arbitrage, Securities Lending

JEL Classification: E43, F31, G15