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

  • Mancini Griffoli, Tommaso


  • Ranaldo, Angelo


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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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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