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Limits to Arbitrage during the Crisis: Finding Liquidity Constraints and Covered Interest Parity

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  • Mancini Griffoli, Tommaso

    ()

  • Ranaldo, Angelo

    ()

Abstract

Arbitrage ensures that covered interest parity holds. The condition is central to price foreign exchange forwards and interbank lending rates, and reflects the efficient functioning of markets. Normally, deviations from arbitrage, if any, last seconds and reach a few basis points. But after the Lehman bankruptcy, arbitrage broke down. By replicating exactly two major arbitrage strategies and using high frequency prices from novel datasets, this paper shows that arbitrage profits were large, persisted for months and involved borrowing in dollars. Empirical analysis suggests that insufficient funding liquidity in dollars kept traders from arbitraging away excess profits.

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File URL: http://www1.vwa.unisg.ch/RePEc/usg/sfwpfi/WPF-1212.pdf
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Bibliographic Info

Paper provided by University of St. Gallen, School of Finance in its series Working Papers on Finance with number 1212.

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Length: 46 pages
Date of creation: Nov 2012
Date of revision:
Handle: RePEc:usg:sfwpfi:2012:12

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Keywords: limits to arbitrage; covered interest parity; funding liquidity; financial crisis; slow moving capital; market freeze; unconventional monetary policy.;

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References

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  12. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
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Citations

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Cited by:
  1. 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.
  2. 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.
  3. 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.
  4. Victoria Ivashina & David S. Scharfstein & Jeremy C. Stein, 2012. "Dollar funding and the lending behavior of global banks," Finance and Economics Discussion Series 2012-74, Board of Governors of the Federal Reserve System (U.S.).
  5. Tiago Severo, 2012. "Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance," IMF Working Papers 12/194, International Monetary Fund.
  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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