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Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity

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  • Tommaso Mancini Griffoli
  • Angelo Ranaldo

Abstract

Arbitrage normally ensures that covered interest parity (CIP) holds. Until recently, excess profits, if any, were documented to last merely seconds and reach a few pips. Instead, this paper finds that following the Lehman bankruptcy, these were large, persisted for months and involved strategies short in dollars. Profits are estimated by specifying the arbitrage strategy as a speculator would actually implement it, considering both unsecured and secured funding. Either way, it seems that dollar funding constraints kept traders from arbitraging away excess profits. The claim finds support in an empirical analysis drawing on several novel high frequency datasets of synchronous quotes across securities, including transaction costs.

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Bibliographic Info

Paper provided by Swiss National Bank in its series Working Papers with number 2010-14.

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Length: 44 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:snb:snbwpa:2010-14

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Keywords: arbitrage limits; covered interest parity; funding liquidity; financial crisis;

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References

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  1. Ricardo Lagos & Guillaume Rocheteau & Pierre-Olivier Weill, 2008. "Crashes and Recoveries in Illiquid Markets," NBER Working Papers 14119, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Tiago Severo, 2012. "Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance," IMF Working Papers 12/194, International Monetary Fund.
  2. Kotaro Ishi & Kenji Fujita & Mark R. Stone, 2011. "Should Unconventional Balance Sheet Policies Be Added to the Central Bank toolkit? a Review of the Experience so Far," IMF Working Papers 11/145, International Monetary Fund.
  3. Victoria Ivashina & David S. Scharfstein & Jeremy C. Stein, 2012. "Dollar Funding and the Lending Behavior of Global Banks," NBER Working Papers 18528, National Bureau of Economic Research, Inc.
  4. Matthew S. Yiu & Joseph K. W. Fung & Lu Jin & Wai-Yip Alex Ho, 2010. "Liquidity Crunch in Late 2008: High-Frequency Differentials between Forward-Implied Funding Costs and Money Market Rates," Working Papers 262010, Hong Kong Institute for Monetary Research.
  5. Yi Wang, 2010. "Convertibility Restriction Determination in China's Foreign Exchange Market and its Impact of Forward Pricing," Discussion Papers 09-024, Stanford Institute for Economic Policy Research.
  6. Fukuda, Shin-ichi, 2012. "Market-specific and currency-specific risk during the global financial crisis: Evidence from the interbank markets in Tokyo and London," Journal of Banking & Finance, Elsevier, vol. 36(12), pages 3185-3196.

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