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The microstructure of covered interest arbitrage in a market with a dominant market maker

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  • Liu, Hao-Chen
  • Witte, Mark David

Abstract

Measured by transaction volume, foreign exchange swaps are the largest market in the world. However, there are very few empirical studies of swap rates. Theoretically, covered interest parity is commonly assumed. But what factors determine arbitrage opportunities? We create a unique microstructure model of exchange rate activity to identify theoretical predictions regarding covered interest arbitrage in a market with a dominant market maker. Using a unique data set of actual, recorded swap transactions, not price quotes, the model is verified as we find economically significant returns that depend in part on market volatility, contract irregularity and trader identity.

Suggested Citation

  • Liu, Hao-Chen & Witte, Mark David, 2013. "The microstructure of covered interest arbitrage in a market with a dominant market maker," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 24(C), pages 25-41.
    • Handle: RePEc:eee:intfin:v:24:y:2013:i:c:p:25-41
    DOI: 10.1016/j.intfin.2012.11.012
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    References listed on IDEAS

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    1. Baba, Naohiko & Packer, Frank, 2009. "From turmoil to crisis: Dislocations in the FX swap market before and after the failure of Lehman Brothers," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1350-1374, December.
    2. Furfine, Craig H., 2004. "Public disclosures and calendar-related movements in risk premiums: evidence from interbank lending," Journal of Financial Markets, Elsevier, vol. 7(1), pages 97-116, January.
    3. Taylor, Mark P, 1989. "Covered Interest Arbitrage and Market Turbulence," Economic Journal, Royal Economic Society, vol. 99(396), pages 376-391, June.
    4. Cho‐Hoi Hui & Hans Genberg & Tsz‐Kin Chung, 2011. "Funding liquidity risk and deviations from interest‐rate parity during the financial crisis of 2007–2009," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 16(4), pages 307-323, October.
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    6. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
    7. Eun, Cheol S. & Sabherwal, Sanjiv, 2002. "Forecasting exchange rates: Do banks know better?," Global Finance Journal, Elsevier, vol. 13(2), pages 195-215.
    8. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 2009. "Understanding the Forward Premium Puzzle: A Microstructure Approach," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(2), pages 127-154, July.
    9. Peter G. Szilagyi & Jonathan A. Batten, 2006. "Arbitrage, Covered Interest Parity and Long-Term Dependence between the US Dollar and the Yen," The Institute for International Integration Studies Discussion Paper Series iiisdp128, IIIS.
    10. Peiers, Bettina, 1997. "Informed Traders, Intervention, and Price Leadership: A Deeper View of the Microstructure of the Foreign Exchange Market," Journal of Finance, American Finance Association, vol. 52(4), pages 1589-1614, September.
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    Cited by:

    1. Hao-Chen Liu & Mark David Witte, 2019. "Preferred Habitat, Window Dressing, or Both? Evidence From Foreign Exchange Swaps in Taiwan," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 22(03), pages 1-20, September.

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    More about this item

    Keywords

    Exchange rates; Covered interest; Foreign exchange microstructure; Forward swap; Hedging;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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