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Segmented money markets and covered interest parity arbitrage

Author

Listed:
  • Dagfinn Rime

    (Norges Bank (Central Bank of Norway) and BI Norwegian Business School)

  • Andreas Schrimpf

    (BIS and CEPR)

  • Olav Syrstad

    (Norges Bank (Central Bank of Norway))

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.

Suggested Citation

  • Dagfinn Rime & Andreas Schrimpf & Olav Syrstad, 2017. "Segmented money markets and covered interest parity arbitrage," Working Paper 2017/15, Norges Bank.
    • Handle: RePEc:bno:worpap:2017_15
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    References listed on IDEAS

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    More about this item

    Keywords

    Covered Interest Parity; Money Market Segmentation; Funding Liquidity Premia; FX Swap Market; U.S. Dollar Funding;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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