Covered interest arbitrage profits: The role of liquidity and credit risk

Wai Ming Fong, Giorgio Valente*, Joseph K W FUNG

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

26 Citations (Scopus)

Abstract

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.

Original languageEnglish
Pages (from-to)1098-1107
Number of pages10
JournalJournal of Banking and Finance
Volume34
Issue number5
DOIs
Publication statusPublished - May 2010

Scopus Subject Areas

  • Finance
  • Economics and Econometrics

User-Defined Keywords

  • Arbitrage
  • Covered interest rate parity
  • Exchange rates
  • Foreign exchange microstructure

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