BIS Working Papers
                                    No 651 
                                    Segmented money 
                                    markets and covered 
                                    interest parity arbitrage  
                                    by Dagfinn Rime, Andreas Schrimpf and Olav Syrstad 
                                     
                                    Monetary and Economic Department 
                                    July 2017 
            
                                    JEL classification: E43, F31, G15 
                                    Keywords: Covered Interest Parity; Money Market 
                                    Segmentation; Funding Liquidity Premia; FX Swap 
                                    Market; U.S. Dollar Funding 
         
         
         
         
         
         
         
         
         
         
         
        BIS Working Papers are written by members of the Monetary and Economic 
        Department of the Bank for International Settlements, and from time to time by 
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        This publication is available on the BIS website (www.bis.org). 
         
         
        ©  Bank for International Settlements 2017. All rights reserved. Brief excerpts may be 
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        ISSN 1020-0959 (print) 
        ISSN 1682-7678 (online) 
         
                                       Segmented Money Markets and
                                    Covered Interest Parity Arbitrage∗
                          Dagfinn Rime                     Andreas Schrimpf                      Olav Syrstad
                    BI Norwegian Business School              BIS & CEPR                         Norges Bank
                       dagfinn.rime@gmail.com           andreas.schrimpf@bis.org         olav.syrstad@norges-bank.no
                                                     First draft: 4th December 2016
                                                      This version: 25th June 2017
                   ∗We are grateful to Claudio Borio, Matt Boge (discussant), Pierre Collin-Dufresne (discussant), Guy Debelle,
                Wenxin Du, Darrell Duffie, Jacob Gyntelberg, Jonathan Kearns, Samuli Knupfer, Daniel Kohler, Frank Packer, Lasse
                                                                                    ¨
                Pedersen, Matteo Maggiori, Semyon Malamud, Bob McCauley, Benjamin Mueller, Pat McGuire, Angelo Ranaldo,
                Lucio Sarno, Hyun Song Shin, Suresh Sundaresan (discussant), Vlad Sushko, Kostas Tsatsaronis, Itay Tuchman
                (discussant), Adrien Verdelhan (discussant) and conference and seminar participants at the BIS symposium “CIP-
                RIP?”, the 5th annual conference in international finance (Cass), The 10th annual Paul Woolley Center conference on
                capital market dysfunctionality (LSE), BI Norwegian Business School, KU Leuven, Gothenburg University, Hamburg
                University, Hitotsubashi University, Bank for International Settlements, Bank of England, Swiss National Bank, and
                Norges Bank for helpful comments. The views in this article are those of the authors and do not necessarily represent
                those of Norges Bank or of the Bank for International Settlements (BIS).
                    Segmented Money Markets and
                   Covered Interest Parity Arbitrage
                                 Abstract
            This paper studies the violation of the most basic no-arbitrage condition in international finance
            – Covered Interest Parity (CIP). To understand the CIP conundrum, it is key to (i) account
            for funding frictions in U.S. dollar money markets, and (ii) to study the challenges of swap
            intermediaries when funding liquidity evolves differently across major currency areas. We find
            that CIP holds remarkably well for most potential arbitrageurs when applying their marginal
            funding rates. With severe funding liquidity differences, however, it becomes impossible for
            dealers to quote prices such that CIP holds across the full rate spectrum. A narrow set of global
            top-tier banks enjoys risk-less arbitrage opportunities as dealers set quotes to avert order flow
            imbalances. We show how a situation with persistent arbitrage profits arises as an equilibrium
            outcome due to the constellation of market segmentation, the abundance of excess reserves and
            their remuneration in central banks’ deposit facilities.
            JEL Classification: E43, F31, G15.
            Keywords: Covered Interest Parity; Money Market Segmentation; Funding Liquidity Premia;
            FXSwapMarket; U.S. Dollar Funding