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Covered interest arbitrage profits: The role of liquidity and credit risk

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  • Fong, Wai-Ming
  • Valente, Giorgio
  • Fung, Joseph K.W.

Abstract

We study the profitability of Covered Interest Parity (CIP) arbitrage violations and their relationship with market liquidity and credit risk using a novel and unique dataset of tick-by-tick firm quotes for all financial instruments involved in the arbitrage strategy. The empirical analysis shows that positive CIP arbitrage deviations include a compensation for liquidity and credit risk. Once these risk premia are taken into account, small arbitrage profits only accrue to traders who are able to negotiate low trading costs. The results are robust to stale pricing and the nonsynchronous trading occurring in the markets involved in the arbitrage strategy.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 34 (2010)
Issue (Month): 5 (May)
Pages: 1098-1107

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Handle: RePEc:eee:jbfina:v:34:y:2010:i:5:p:1098-1107

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Web page: http://www.elsevier.com/locate/jbf

Related research

Keywords: Exchange rates Arbitrage Covered interest rate parity Foreign exchange microstructure;

References

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Citations

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Cited by:
  1. Hans Jørgen Tranvåg & Dagfinn Rime, 2012. "The Flows of the Pacific: Asian foreign exchange markets through tranquility and turbulence," Working Paper Series 12412, Department of Economics, Norwegian University of Science and Technology.
  2. King, Michael & Sarno, Lucio & Sojli, Elvira, 2010. "Timing exchange rates using order flow: The case of the Loonie," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 2917-2928, December.
  3. Chiu, Junmao & Chung, Huimin & Ho, Keng-Yu & Wang, George H.K., 2012. "Funding liquidity and equity liquidity in the subprime crisis period: Evidence from the ETF market," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2660-2671.
  4. Pippenger, John, 2012. "What Covered Interest Parity Implies about the Theory of Uncovered Interest Parity," University of California at Santa Barbara, Economics Working Paper Series qt0zk6t2hj, Department of Economics, UC Santa Barbara.
  5. Baba, Naohiko & Sakurai, Yuji, 2011. "When and how US dollar shortages evolved into the full crisis? Evidence from the cross-currency swap market," Journal of Banking & Finance, Elsevier, vol. 35(6), pages 1450-1463, June.
  6. Silviu Eduard Dinca, 2013. "Unwinding RON carry-trade or RON speculative attack?," Finante - provocarile viitorului (Finance - Challenges of the Future), University of Craiova, Faculty of Economics and Business Administration, vol. 1(15), pages 193-205, December.
  7. Juan R. Hernández, 2014. "Peso-Dollar Forward Market Analysis: Explaining Arbitrage Opportunities during the Financial Crisis," Working Papers 2014-09, Banco de México.
  8. John, Pippenger, 2011. "The solution to the forward-bias puzzle: Reply," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 21(4), pages 629-636, October.
  9. Yang, Hsin-Feng & Liu, Chih-Liang & Chou, Ray Yeutien, 2014. "Interest rate risk propagation: Evidence from the credit crunch," The North American Journal of Economics and Finance, Elsevier, vol. 28(C), pages 242-264.

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