Arbitraging Covered Interest Rate Parity Deviations and Bank Lending

66 Pages Posted: 19 Feb 2021

Date Written: February 9, 2021

Abstract

I propose and test a new channel through which bank lending is affected in an emerging markets setting. This channel is that when banks arbitrage covered interest rate parity (CIP) deviations, they need to borrow in a particular currency. In the presence of borrowing frictions, they shift part of the resources used to lend to households and firms to fund their arbitrage activities. I exploit differences the abilities of Peruvian banks to arbitrage CIP deviations to show that banks that have greater ability to arbitrage reduce their lending in the currency they need to fund their CIP arbitrage. This is compensated by lending in a different currency. Therefore, arbitraging CIP deviations lead to changes in the currency composition of lending.

Keywords: CIP Deviations, Arbitrage, Bank Lending

JEL Classification: F30, G15

Suggested Citation

Keller, Lorena, Arbitraging Covered Interest Rate Parity Deviations and Bank Lending (February 9, 2021). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=3782607 or http://dx.doi.org/10.2139/ssrn.3782607
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