Working Paper: CEPR ID: DP14774
Authors: Patrick Augustin; Mikhail Chernov; Lukas Schmid; Dongho Song
Abstract: We quantify the impact of risk-based and non-risk-based intermediary constraints (IC) on the term structure of CIP violations. Using a stochastic discount factor (SDF) inferred from interest rate swaps, we value currency derivatives. The wedge between model-implied and observed derivative prices reflects the impact of non-risk-based IC because our SDF incorporates risk-based IC. There is no wedge at short horizons, while the wedge accounts for 30% of long-term CIP violations. Consistent with IC theory, the wedge correlates with the shadow cost of intermediary capital, and the SDF-implied interest rate is a weighted average of collateralized and uncollateralized interest rates.
Keywords: CIP violations; forwards; swaps; no-arbitrage valuation
JEL Codes: C1; E43; E44; G12; H60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Intermediary constraints (D10) | CIP violations (K42) |
| Non-risk-based intermediary constraints (G21) | CIP violations (K42) |
| Risk-based intermediary constraints (G21) | CIP violations (K42) |
| SDF (C69) | Pricing mechanisms in currency derivatives (G13) |
| Wedge between model-implied and observed prices (G19) | Non-risk-based intermediary constraints (G21) |
| CIP violations (K42) | Intermediary constraints (D10) |