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The microstructure of covered interest arbitrage in a market with a dominant market maker

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  • Liu, Hao-Chen
  • Witte, Mark David

Abstract

Measured by transaction volume, foreign exchange swaps are the largest market in the world. However, there are very few empirical studies of swap rates. Theoretically, covered interest parity is commonly assumed. But what factors determine arbitrage opportunities? We create a unique microstructure model of exchange rate activity to identify theoretical predictions regarding covered interest arbitrage in a market with a dominant market maker. Using a unique data set of actual, recorded swap transactions, not price quotes, the model is verified as we find economically significant returns that depend in part on market volatility, contract irregularity and trader identity.

Suggested Citation

  • Liu, Hao-Chen & Witte, Mark David, 2013. "The microstructure of covered interest arbitrage in a market with a dominant market maker," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 24(C), pages 25-41.
    • Handle: RePEc:eee:intfin:v:24:y:2013:i:c:p:25-41
    DOI: 10.1016/j.intfin.2012.11.012
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    References listed on IDEAS

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    5. Taylor, Mark P, 1987. "Covered Interest Parity: A High-Frequency, High-Quality Data Study," Economica, London School of Economics and Political Science, vol. 54(216), pages 429-438, November.
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    Cited by:

    1. Hao-Chen Liu & Mark David Witte, 2019. "Preferred Habitat, Window Dressing, or Both? Evidence From Foreign Exchange Swaps in Taiwan," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 22(03), pages 1-20, September.

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    More about this item

    Keywords

    Exchange rates; Covered interest; Foreign exchange microstructure; Forward swap; Hedging;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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