Department of Finance & Decision Sciences
Covered interest arbitrage profits: The role of liquidity and credit risk
We study the profitability of Covered Interest Parity (CIP) arbitrage violations and their relationship with market liquidity and credit risk using a novel and unique dataset of tick-by-tick firm quotes for all financial instruments involved in the arbitrage strategy. The empirical analysis shows that positive CIP arbitrage deviations include a compensation for liquidity and credit risk. Once these risk premia are taken into account, small arbitrage profits only accrue to traders who are able to negotiate low trading costs. The results are robust to stale pricing and the nonsynchronous trading occurring in the markets involved in the arbitrage strategy. © 2009 Elsevier B.V. All rights reserved.
Arbitrage, Covered interest rate parity, Exchange rates, Foreign exchange microstructure
Source Publication Title
Journal of Banking and Finance
Fong, Wai-Ming, Giorgio Valente, and Joseph K.W. Fung. "Covered interest arbitrage profits: The role of liquidity and credit risk." Journal of Banking and Finance 34.5 (2010): 1098-1107.