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:	July 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 the recent literature on persistent deviations from covered interest parity (CIP) by showing theoretically that CIP violations imply arbitrage opportunities only if uncollateralized interbank lending rates are riskless. In the absence of observable riskless discount rates, we extract them empirically using a simple no-arbitrage framework. They deliver novel quantitative benchmarks for foreign exchange contracts that match observed forward currency premiums and cross-currency basis swap rates well. The no-arbitrage benchmarks account for about two thirds of the alleged CIP deviations, while the residual pricing errors line up with measures of intermediary constraints and the expensiveness of the U.S. dollar.