Working Paper: CEPR ID: DP13637
Authors: Dagfinn Rime; Andreas Schrimpf; Olav Syrstad
Abstract: We show that it is crucial to account for the heterogeneity in funding costs, both across banks and across currency areas, in order to understand recently documented deviations from Covered Interest Parity (CIP). When CIP arbitrage is implemented accounting for marginal funding costs and realistic risk-free investment instruments, the no-arbitrage relation holds fairly well for the majority of market participants. A narrow set of global high-rated banks, however, does enjoy riskless arbitrage opportunities. Such arbitrage opportunities emerge as an equilibrium outcome as FX swap dealers set prices to avoid inventory imbalances. Low-rated banks find it attractive to turn to the FX swap market to cover their U.S. dollar funding, while swap dealers elicit opposite (arbitrage) flows by high-rated banks. Such arbitrage opportunities are difficult to scale, with funding rates adjusting as soon as arbitrageurs increase their positions.
Keywords: Covered Interest Parity; US Dollar Funding; Funding Liquidity Premia; FX Swap Market
JEL Codes: E43; F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| marginal funding costs (G32) | deviations from covered interest parity (CIP) (F31) |
| bank ratings (G21) | arbitrage opportunities (F31) |
| funding costs (G32) | arbitrage opportunities (F31) |
| FX swap market (G15) | funding for low-rated banks (G21) |
| funding liquidity conditions (E50) | pricing of swaps (G13) |
| pricing of swaps (G13) | arbitrage opportunities (F31) |