Norges Bank

Working Paper

Segmented money markets and covered interest parity arbitrage

Author:
Dagfinn Rime, Andreas Schrimpf and Olav Syrstad
Series:
Working Paper
Number:
15/2017

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.

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ISSN 1502-8190 (online)

Published 6 September 2017 09:05
Published 6 September 2017 09:05