INTERNATIONAL

FINANCE

12/2/2025
Dr Alexandros Skouralis Lecture 3
[email protected] Covered Interest Parity & Arbitrage
 MODULE OUTLINE

 Lecture 1: The Exchange rate markets

 Lecture 2: Exchange rate regimes & Impossible Trinity
 Lecture 3: Covered Interest Parity (CIP) & Arbitrage
 Lecture 4: Uncovered Interest Parity (UIP)
 Lecture 5: Carry trade strategy (empirical literature and examples)
 Lecture 6: Purchase Power Parity (PPP)
 Lecture 7: Structural Models for Exchange rate determination
 Lecture 8: Forecasting Exchange rates
 Lecture 9: The International Monetary System
 Lecture 10: Revision & Mock Exam
LECTURE 2: EXCHANGE RATE REGIMES

Foreign Exchange Intervention:

 Capital/Exchange controls
 Open Market Operations
THE SWISS FRANC (CHF)
GLOBAL RESERVES

 Liquid reserves allow countries significant leverage in

economic policies and trade wars.
 China currently holds over $3 trillion in reserves, far
higher than Japan’s second-place $1.24 trillion in reserves.
China also holds a significant amount of U.S. debt.
 If China were to sell off its reserves, it would have
cascading effects on the economy, including driving up
U.S. interest rates.
FEBRUARY 6, 2025: INTEREST RATE CUT

BoE
Database
IMPOSSIBLE TRINITY OR THE TRILEMMA

 Key Framework: The Policy Trilemma

 Definition: Countries face a trade-off among three
key policy goals:
• Free Capital Movement: Allowing capital to move
freely across borders.
• Fixed Exchange Rate: Maintaining a stable exchange
rate by pegging to a foreign currency.
• Monetary Policy Independence: Retaining the ability
to set independent monetary policy.
 Implication: A country can achieve only two out of
the three goals simultaneously, but not all three.
 TRILEMMA OR DILEMMA?

 Traditionally, adopting a floating exchange rate was believed to provide monetary policy
independence by insulating countries from foreign shocks.
 However, financial globalization undermines this.
According to Rey (2018), global financial conditions are largely determined by major centres like the U.S. Federal
Reserve. When the Fed tightens monetary policy, it increases the global risk premium, causing capital to flow
from emerging markets to safe-haven assets (e.g., U.S. dollar, Swiss franc). This happens regardless of a
country’s exchange rate regime.
 As a result, even countries with floating exchange rates remain exposed to U.S. monetary shocks,
forcing them to respond by adjusting their policies. This interconnectedness of global financial
markets makes monetary policy independence difficult, effectively reducing the trilemma to a
dilemma.
 Rey’s solution to this dilemma is the use of capital controls and macroprudential policies:
• Countries need capital flow management tools to limit the destabilizing effects of global financial cycles.
• Macroprudential regulation can help reduce vulnerabilities in the financial system.
 TRILEMMA OR DILEMMA?

 Given the global capital cycle, do exchange rate regimes still matter? Surprisingly little
 Countries with a more rigid regime are not noticeably more affected by the US financial cycle than
countries with more flexible exchange rate regimes
• This holds for both advanced and emerging market countries
• But floating countries do seem more affected by their own economic conditions than fixed countries
 Even a country with a fully freely-floating exchange rate regime following inflation targeting that
should be most isolated from US policy changes (the UK) still sees mortgage rates heavily influenced
by US shocks
• Same holds for other countries with “independent regimes” like Canada, NZ and Sweden
• But countries with a fixed regime are more affected by core economy shocks than floaters

There is only a dilemma: Independent monetary policies are possible if and only if the capital
account is managed. The exchange rate regime is irrelevant.
 ADVANTAGES OF FIXED EXCHANGE RATE REGIME
SEE ALSO PILBEAM, INTERNATIONAL FINANCE 2023 BOOK, CHAPTER 10.2

1. Monetary Policy Discipline

A fixed exchange rate helps control inflation by serving as a credible commitment for monetary policy. It limits a central
bank’s discretion to expand the money supply, reducing inflation expectations among workers and firms.
2. Facilitating trade
Exchange rate stability reduces uncertainty and transaction costs in international trade. A fixed exchange rate eliminates
currency fluctuations, encouraging more trade between countries.
3. Facilitating Investment (International Capital Flows)
Similar to trade, stable exchange rates reduce uncertainty for international investors and lower risk premiums. This helps
attract foreign capital and supports financial market stability.
4. Precluding Competitive Depreciation
Prevents countries from engaging in "currency wars" where each nation tries to devalue its currency to gain a trade
advantage, leading to inefficiencies and instability in global trade.
5. Avoidance of Speculative Attacks (Under Credible Pegs)
Reduces excessive fluctuations in exchange rates that are not driven by economic fundamentals but by market
speculation, thus promoting a more stable economic environment.
 ADVANTAGES OF FLOATING EXCHANGE RATE REGIME
SEE ALSO PILBEAM, INTERNATIONAL FINANCE 2023 BOOK, CHAPTER 10.3

1. National Independence for Monetary Policy

A floating exchange rate allows a country to have an independent monetary policy, meaning it can respond to domestic economic shocks
(e.g., recessions) without being constrained by balance-of-payments concerns. Under fixed exchange rates, monetary policy is tied to
maintaining the peg, which limits its ability to stabilize domestic output and employment.
2. Automatic Adjustment to Trade Shocks
A flexible exchange rate automatically adjusts in response to external shocks, such as a decline in export demand or unfavorable changes
in the terms of trade. If a country faces a trade shock, its currency will depreciate, making exports cheaper and imports more expensive,
helping to restore equilibrium.
3. Retaining Seigniorage
Seigniorage (the profit a central bank makes from issuing currency) is lost when a country pegs its currency to another or joins a monetary
union. With a floating exchange rate, the central bank can create money as needed, allowing the country to retain this source of revenue.
4. Retaining Lender-of-Last-Resort Capability
A central bank with a floating exchange rate can act as a lender of last resort to the banking system, creating money when necessary to bail
out troubled banks. Under a rigid peg, the central bank’s ability to do this is constrained by the need to maintain foreign exchange reserves.
5. Avoiding Speculative Attacks
Fixed exchange rates are vulnerable to speculative attacks, where investors bet against the currency and force a devaluation, often
triggering financial crises (e.g., Argentina 2001, various 1990s currency crises). A floating exchange rate reduces the risk of such attacks
since the exchange rate is always adjusting rather than being artificially maintained at a fixed level.
 CHOICE OF THE REGIME

The factors behind the choice of an exchange rate regime include the following nine characteristics that
influence whether a country is better suited for a fixed or floating exchange rate:

 Small Size and Openness

Countries with a high ratio of tradable goods to GDP benefit more from fixing, as it facilitates trade. The advantages of
floating, such as monetary policy independence, are less relevant for them.
 Trade and Investment Ties with a Major Currency Partner
If a country trades heavily with a single dominant partner, fixing its exchange rate to that partner’s currency can reduce
uncertainty and transaction costs.
 Symmetry of Shocks
If a country’s economic fluctuations are closely correlated with those of the currency it pegs to, then giving up monetary
policy independence is less costly. Otherwise, asymmetric shocks would require independent monetary policy, making
floating preferable.
 Labour Mobility
If workers can easily move between regions, labour mobility can serve as an adjustment mechanism in the absence of
exchange rate flexibility (e.g., within the U.S.). If labour is immobile, floating rates provide a necessary adjustment tool.
 CHOICE OF THE REGIME

 Countercyclical Fiscal Transfers

If a country belongs to a monetary union where fiscal transfers cushion economic downturns (e.g., U.S. federal transfers to
states), it may function well under a fixed exchange rate. Most international arrangements lack such mechanisms.
 Countercyclical Remittances
Countries that receive significant remittances from workers abroad may be more suited to a fixed exchange rate. If
remittances rise when the domestic economy struggles, they help stabilize the economy even without independent monetary
policy.
 Political Willingness to Cede Monetary Sovereignty
National identity and political resistance to foreign monetary influence play a role. Some countries strongly prefer retaining
their own currency, making fixed exchange rate regimes politically difficult.
 Level of Financial Development
Countries with underdeveloped financial markets benefit from fixed exchange rates, as floating rates can introduce financial
instability. More developed economies can handle the volatility of floating regimes.
 Origin of Economic Shocks
If a country faces mostly internal demand shocks (e.g., unstable domestic policies), fixed rates can provide stability. If it faces
mostly external supply shocks (e.g., commodity price swings, natural disasters, terms of trade volatility), floating rates allow
better adjustment.
 CHOICE OF THE REGIME | EMPIRICAL EVIDENCE

 Preference for fixed versus floating can appear ideological:

• A preference for market-determined solutions leads to a floating regime
• A suspicion of how markets work can lead to a preference for fixed regimes
 Or even cultural:
• Cao et al (2018) argue that national cultural characteristics can guide the choice of exchange rate regime.
• They show that individualistic societies are more likely to choose floating regimes because their economic
agents are independent, overconfident, and have higher levels of risk tolerance
• Individualistic societies are also associated with better financial development, fewer capital controls, and more
democratic institutions, which are all tied to a higher probability of choosing a floating exchange rate regime
 MODULE OUTLINE

 Lecture 1: The Exchange rate markets

 Lecture 2: Exchange rate regimes & Impossible Trinity
 Lecture 3: Covered Interest Parity (CIP) & Arbitrage
 Lecture 4: Uncovered Interest Parity (UIP)
 Lecture 5: Carry trade strategy (empirical literature and examples)
 Lecture 6: Purchase Power Parity (PPP)
 Lecture 7: Structural Models for Exchange rate determination
 Lecture 8: Forecasting Exchange rates
 Lecture 9: The International Monetary System
 Lecture 10: Revision & Mock Exam
 PARITY RELATIONSHIPS IN INTERNATIONAL FINANCE

 Three parity concepts underlie most of our understanding of Foreign exchange rate behaviour:
1. Covered interest rate parity (CIP)
2. Uncovered interest rate parity (UIP)
3. Purchasing power parity (PPP)
 We will discuss these in turn, in each case first explaining the concept, then providing empirical
evidence on the validity of the relationship and finally drawing practical implications from the
evidence
 COVERED INTEREST PARITY (CIP)

 CIP is essentially a form of law of one price in the international financial market.
 In this lecture we will introduce the concept, when does it hold and how to trade strategies that can
be proven profitable.
 To illustrate CIP, we consider two risk-free investment strategies:
1) In the first strategy, you invest in a domestic risk-free asset, such as treasury bills or bank deposits, where
the return is predetermined by a fixed domestic interest rate. Assuming no default risk from the government or
high-quality domestic banks, you know exactly how much you will receive at the end of the investment period.
2) In the second strategy, you convert domestic currency into foreign currency through the spot exchange
market, invest in a foreign risk-free asset, and hedge the currency risk by entering a forward contract to fix the
future exchange rate for converting the foreign currency back to domestic currency. Because both the foreign
interest rate and the exchange rate are locked in at the beginning, the final domestic currency return is known
with certainty.
 For CIP to hold, the returns from these two strategies must be equal. This equality ensures
that no arbitrage opportunity exists between domestic and foreign investments. If CIP holds, the
relationship between the spot exchange rate, the forward exchange rate, the domestic interest rate,
and the foreign interest rate will be in equilibrium.
THE CONCEPT OF CIP
THE CONCEPT OF CIP
CIP DEVIATION MEASURED IN MONETARY TERMS
 In order to test whether Covered Interest Parity (CIP) holds using market data, we need to account for real-world
complexities such as bid-ask spreads and interest rate conventions in different markets. Exchange rates are quoted in
two-way style (bid and ask), so it's useful to calculate the middle price as the average of the bid and ask to reflect the
current market position.
 To check for CIP violations, consider the US dollar and British pound markets. We need the following data:
1. The annualized interest rate for US dollar-denominated deposits.
2. The annualized interest rate for British pound-denominated deposits.
3. The spot exchange rate for converting dollars to pounds.
4. The forward exchange rate for converting pounds back to dollars.
 Since interest rates are quoted as annualized rates, adjustments are necessary for different investment horizons. For
example, if the horizon is one month, you typically divide the annualized rate by 12. However, market conventions differ:
the US dollar money market assumes 360 days per year, while the British pound money market assumes 365 days
per year.
 For a one-month investment, if the actual number of days is 28, the adjustment factor (tau) for the dollar market is
28/360. For the pound market, the factor is 28/365. These factors are applied to convert the annualized interest rates to
the appropriate horizon.
 To test CIP, compare the gross return on a risk-free dollar investment to the hedged return from a pound-denominated
investment. By calculating these adjusted returns using market data, we can determine if CIP holds or if there are
violations, and if so, analyse the nature of the discrepancies.
CIP DEVIATION MEASURED BY THE DOLLAR BASIS

 Dollar basis generally refers to the difference between the interest rate on a foreign currency and the
implied interest rate derived from the foreign exchange (FX) swap market when swapping that
foreign currency back into U.S. dollars. This is commonly known as the cross-currency basis or FX
basis.
 In financial markets, especially in the context of international funding and hedging, dollar basis
measures how expensive or cheap it is to borrow U.S. dollars relative to borrowing in another currency
and swapping back to dollars through the FX market.
CIP DEVIATION MEASURED BY THE DOLLAR BASIS
CIP DEVIATIONS MEASURED BY THE DOLLAR BASIS
CIP DEVIATIONS MEASURED BY THE DOLLAR BASIS

• Steps to Identify Arbitrage Opportunities:

1. Access Market Data: Gather interest rates, spot exchange rates, and forward exchange rates for the relevant
currencies (e.g., USD and GBP).

2. Calculate the Dollar Basis: Compute the difference in gross returns between domestic and hedged foreign
investments.

3. Analyse the Dollar Basis: If the basis is zero, CIP holds, and no arbitrage exists. If non-zero, determine the
arbitrage strategy based on the sign and estimate potential profits based on the magnitude.

4. Execute Arbitrage: Borrow in the appropriate currency, invest in the corresponding risk-free asset, and hedge
exchange rate risk using forward contracts.
CIP DEVIATIONS MEASURED BY THE DOLLAR BASIS

• Challenges and Considerations:

1. Transaction Costs: Actual arbitrage profits may be reduced by transaction costs and
market frictions.

2. Practical Implementation: Even with clear arbitrage signals, factors like market
conditions, liquidity, and execution speed can affect the ability to exploit CIP violations
effectively.
BREAK-EVEN RULES
BREAK EVEN RULES – ROUND TRIP ARBITRAGE

 The first step is to check if the arbitrage profits computed from the initial analysis survive
transaction costs. For example, if the dollar basis is negative, the strategy involves
borrowing in dollars, converting to pounds in the spot market, investing in sterling-
denominated risk-free assets, and hedging the exchange rate risk using a forward
contract.
 Executing this strategy requires accessing four markets:
- the dollar money market to borrow dollars,
- the spot foreign exchange market to convert dollars to pounds,
- the UK money market to invest in sterling assets and
- the forward foreign exchange market to lock in the future exchange rate for converting pounds
back to dollars.
BREAK EVEN RULES – ROUND TRIP ARBITRAGE

 Each of these markets involves bid-ask spreads, and the transaction costs associated
with these spreads affect potential profits.
 When borrowing dollars, banks charge the higher (ask) interest rate. In the spot
market, converting dollars to pounds yields fewer pounds because the transaction uses
the higher (offer) exchange rate. When depositing pounds in a UK bank, the lower
(bid) interest rate applies. At the end of the investment period, converting pounds
back to dollars using the forward market results in fewer dollars because the
transaction uses the lower (bid) forward rate.
 These bid-ask spreads and interest rate differentials reduce the potential arbitrage profit.
BREAK EVEN RULES – ROUND TRIP ARBITRAGE
BREAK EVEN RULES – ROUND TRIP ARBITRAGE

 To determine if the trade is profitable, the net profit after transaction costs must be calculated. If the net profit is
zero or negative, the arbitrage trade is not profitable due to transaction costs.

 In the opposite scenario, when the dollar basis is positive, the strategy would be to borrow pounds, convert to
dollars, invest in US risk-free assets, and hedge the exchange rate risk. The same transaction cost test applies,
and if net profits are zero or negative, the trade is unprofitable.

 A common mistake is assuming that if the initial trade (based on a negative dollar basis) fails to survive
transaction costs, switching to the opposite trade will yield profits. However, if the dollar basis is negative, the
opposite trade is inherently unprofitable, even before considering transaction costs. Executing the opposite
trade would only result in greater losses once transaction costs are included.
NEUTRAL BAND
ADDITIONAL CONSIDERATIONS

 The first consideration is the dealers’ advantage. Market data often come from sources like Bloomberg or Reuters and reflect
the most favourable conditions available to dealers, who have access to highly liquid markets and the narrowest bid-ask
spreads. The spreads for non-dealers are typically wider, making it more expensive to execute trades compared to what the raw
data suggest. This means that conclusions drawn from dealer-level data may not hold for other market participants.

 The second consideration is consistency. Even if you have access to favourable conditions similar to those enjoyed by dealers
or hedge funds, there are still issues with the magnitude and persistence of the arbitrage opportunities. Passing the transaction
cost test does not guarantee that arbitrage opportunities will be consistently large or frequent enough to justify entering the
business. For example, if CIP arbitrage is profitable only for a few isolated moments over a ten-year period, then the opportunity
is too rare to be viable.

 The nature of arbitrage requires significant upfront investment in infrastructure, trading platforms, and establishing relationships
with banks across different money markets and foreign exchange markets. These fixed costs need to be justified by a steady
flow of profitable opportunities. If the potential for profit is infrequent, the cost of setting up and maintaining the business may
outweigh the benefits.
 EVIDENCE FROM THE LITERATURE

 Typical trading days - Taylor (1987):

• Data every ten minutes over three days in
1985
• Four investment horizons (1, 3, 6, 12
months)
• Three currencies ($, £ and DEM) 144 data
points per day per currency pair per horizon
per trade direction or 3456 tests of CIP.
• He found 1 profitable opportunity
(borrow DEM, lend $, 12 months).
• $1million deal earned $200 profit
• Excluding brokers fees
 EVIDENCE FROM THE LITERATURE

 Taylor (1989) looked at five turbulent trading days

• £ 1967 devaluation within Bretton Woods system
• Float of £ at breakdown of Bretton Woods
• Start of ERM (£ not a fixed rate member)
• 1979 and 1987 UK General Elections
Profitable opportunities exist and persist in turbulent
times ($4k- $8k in $1 million deal)

First empirical evidence:

- Unreasonable to expect arbitrage profits to exist long in efficient markets.
- But arbitrage paradox suggests that if arbitrage profits never exist there isn’t the incentive for
arbitrageurs to monitor the market.
 EVIDENCE FROM THE LITERATURE

 Akram et al. (2008) conducted a similar study using high-

quality, time-stamped data to match transaction instruments
precisely.
 Details:
• Tick-by-tick spot, swap (spot-fwd) and deposit rate data
• EUR, JPY, GBP over seven months
 Find that trading against CIP is loss-making on average.
However, they also find that thousands of profitable arbitrage
opportunities exist for each currency and each investment
horizon.
 Arbitrage opportunities present only around 1% of time.
 Their findings aligned with earlier research, showing that CIP
generally holds. While violations sometimes occur, they are
short-lived and seldom large enough to exceed transaction
costs.
POST-GFC PERSISTENTLY NEGATIVE DOLLAR BASIS
 POST-GFC PERSISTENTLY NEGATIVE DOLLAR BASIS

 Before the 2008-2009 Global Financial Crisis (GFC), CIP generally held, with the dollar basis being
very close to zero. This was consistent with traditional wisdom and earlier empirical findings by
academics and market practitioners.
 However, the GFC led to significant deviations from CIP, shown by a sharply negative dollar basis.
These deviations were consistent with Taylor’s 1989 findings, which documented that during
turbulent market conditions, violations of price relationships, including CIP, frequently occur due to
market dislocations.
 The puzzle arises because, if these deviations were purely a result of the financial crisis, CIP should
have returned to its pre-crisis norm once markets calmed, and the economy recovered. However,
even after the GFC and during the subsequent European sovereign debt crisis, the dollar basis
remained persistently negative. This trend continued even after the peak of the European crisis,
suggesting a structural shift rather than a temporary market disruption.
 More recent empirical analyses confirm that the dollar basis remains persistently negative, hovering
around -50 basis points. This indicates that CIP has not returned to its pre-crisis behaviour,
challenging the traditional view that CIP holds under normal market conditions.
POST-GFC PERSISTENTLY NEGATIVE DOLLAR BASIS
 CRISIS EXPERIENCE

 Crisis experience Pre-2007:

• All deviations less than 25bp
• >95% of deviations less than 10bp
• Highly liquid market with virtually perfect capital mobility between short-term EUR and USD instruments
 Post-2007:
• Deviations in the 40-50bp range the norm, much higher peaks
• Deviations one-sided – reflecting shortage of USD liquidity outside of US as interbank lending died
• One policy response to crisis was to open up USD FX swap lines so foreign banks could borrow domestic
currency and swap into USD
 DU ET AL. (2018) | JOURNAL OF FINANCE

Key Empirical Findings:

- CIP deviations are larger for currencies with lower liquidity and higher risks. Window dressing refers
to the practice where
- The deviations are particularly pronounced around quarter-ends, reflecting financial institutions or
fund managers adjust
"window dressing" practices by banks to reduce liabilities on their balance
their portfolios or balance
sheets. sheets just before the
end of a reporting period
- There is clear evidence that regulatory changes post-GFC amplified balance to make their financial
sheet constraints, but these alone do not explain the observed patterns. statements appear more
favorable to regulators,
 Implications: Du et al. (2018) argue that the interplay between regulatory investors, or the public.
changes, market segmentation, and structural demand for the dollar has
fundamentally altered the dynamics of CIP.
 Their findings suggest that solving CIP violations in the post-GFC world would
require not only addressing regulatory inefficiencies but also tackling broader
market frictions and structural imbalances in global dollar funding.
 DU ET AL. (2018) | JOURNAL OF FINANCE

 Du et al (2018) investigate the persistent violations of Covered Interest Parity (CIP) in the post-Global Financial Crisis (GFC) period. Their central
argument is that the persistently negative dollar basis observed in the market cannot be solely attributed to increased balance sheet costs arising
from tighter bank regulation. While such regulatory changes play a role, they argue that other structural and market-specific factors also
significantly contribute to these deviations:

1. Balance Sheet Costs: Tighter regulations after the GFC, such as higher capital requirements and liquidity coverage ratios, have increased the cost
of maintaining large balance sheets. This discourages arbitrageurs (such as banks) from exploiting CIP violations, leading to persistent deviations.

2. Market Segmentation: Market segmentation plays a crucial role in explaining the heterogeneity of dollar basis deviations across different
currencies. Certain currencies exhibit more pronounced or even positive deviations because of varying demand and supply dynamics in cross-
currency funding markets.

3. Demand for Dollar Funding: A structural factor driving the negative dollar basis is the high global demand for dollar funding. Non-U.S. banks often
rely on the U.S. dollar for liabilities while earning revenues in other currencies. This mismatch increases their need to hedge, pushing the basis
negative.

4. Risk Appetite and Limits to Arbitrage: Arbitrage in FX markets requires access to dollar funding, which becomes constrained during times of
financial stress or quarter-end reporting periods due to banks' reluctance to expand their balance sheets. This results in a larger dollar basis closer
to quarter-end, even for short horizons.

5. Central Bank Policies: The paper also highlights the role of central bank policies, such as interest rate differentials and quantitative easing
programs, in influencing the demand and supply of cross-currency swaps. These policies differ across regions, further explaining the
heterogeneity in CIP deviations.