Working Paper: NBER ID: w26009
Authors: Wenxin Du; Benjamin M. Hbert; Amy Wang Huber
Abstract: Violations of no-arbitrage conditions measure the shadow cost of intermediary constraints. Intermediary asset pricing and intertemporal hedging together imply that the risk of these constraints tightening is priced. We describe a “forward CIP trading strategy” that bets on CIP violations shrinking and show that its returns help identify the price of this risk. This strategy yields the highest returns for currency pairs associated with the carry trade. The strategy’s risk contributes substantially to the volatility of the stochastic discount factor, is correlated with both other near-arbitrages and intermediary wealth measures, and appears to be priced consistently across various asset classes.
Keywords: intermediary constraints; CIP violations; asset pricing; risk premium
JEL Codes: F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| intermediary constraints tightening (D10) | risk premium in asset prices (G19) |
| CIP deviations (L15) | profitability of forward CIP trading strategy (G13) |
| intermediary wealth (D31) | performance of forward CIP trading strategy (G13) |
| intermediary constraints (D10) | risk premium across various asset classes (G19) |
| stochastic discount factor (D15) | intermediary wealth returns (G19) |
| stochastic discount factor (D15) | magnitude of CIP violations (K42) |