DP14774 A no-arbitrage perspective on global arbitrage opportunities

Author(s): Patrick Augustin, Mikhail Chernov, Lukas Schmid, Dongo Song
Publication Date: May 2020
Date Revised: May 2020
Keyword(s): Anomalies, CIP violations, negative swap rates, no- arbitrage, Treasury basis
JEL(s): C1, E43, E44, G12, H60
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14774

We revisit covered interest parity (CIP) deviations using a no-arbitrage framework. We show theoretically that CIP violations imply arbitrage opportunities only if uncollateralized interbank lending rates are risk free. Empirically, we treat discount rates as latent. We extract them from each country's interest rate swaps and use them to evaluate term structures of forward premiums and cross-currency basis swaps. We match observed forward currency premiums and generate time-series patterns and magnitudes of cross-currency basis swap rates that are broadly consistent with the evidence. We connect our evidence to other prominent phenomena: non-zero Treasury cross-currency forward basis and negative interest rate swap spreads over Treasuries. Our model-implied discount rates are explained by a linear combination of Treasury interest rate and credit risk, convenience premium, and interbank risk. Our residual pricing errors line up with measures of intermediary constraints and the expensiveness of the U.S. dollar, lending support to models of intermediary based asset pricing for quantitatively realistic results.