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Session Overview
IF-1: CIRP & Carry
Saturday, 26/Aug/2017:
9:00am - 10:30am

Session Chair: Wenxin Du, Federal Reserve Board
Location: O129

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Optimal Factor Strategy in FX Markets

Thomas Maurer1, Thuy-Duong To2, Ngoc-Khanh Tran1

1Washington University in St. Louis; 2University of New South Wales

Discussant(s): Pasquale Della Corte (Imperial College Business School)

We construct a dynamic currency trading strategy that earns a remarkable out-of-sample Sharpe ratio of 1.04 before and 0.78 after transaction costs. It substantially outperforms other popular carry trade strategies in terms of Sharpe ratio, skewness, kurtosis, maximum drawdown, expected recovery time, and percentage of positive returns. Popular factor pricing models in international finance do not explain the superior performance. Our strategy predicts future (1- to 24-month ahead) returns and changes in global FX market volatility. A pricing model using our trading strategy as a single factor outperforms and fully replaces the popular "Dollar"-"Carry" two factor pricing model.

EFA2017-187-IF-1-Maurer-Optimal Factor Strategy in FX Markets.pdf

Segmented Money Markets and Covered Interest Parity Arbitrage

Dagfinn Rime1, Andreas Schrimpf2, Olav Syrstad3

1BI Norwegian Business School; 2Bank for International Settlements; 3Norges Bank

Discussant(s): Bernd Schlusche (Federal Reserve Board)

This paper studies the validity of Covered Interest Parity (CIP) - once seen as the most robust no-arbitrage relationship in international finance, but now deemed broken. We argue it is crucial to account for the effects of money market segmentation and funding liquidity premia, especially in the post-crisis environment characterized by a significant dispersion of money market rates. We find that CIP in fact holds remarkably well when considering money market rates that adequately capture funding liquidity premia. Our approach informs about the forces that effectively limit arbitrage activity in FX swaps and money markets. While arbitrage opportunities are difficult to reap for the vast majority of players, a narrow set of banks does indeed face risk-less arbitrage opportunities. These arise from the constellation of money market segmentation, the abundance of excess reserves and their remuneration in central banks’ deposit facilities.

EFA2017-1181-IF-1-Rime-Segmented Money Markets and Covered Interest Parity Arbitrage.pdf

Limits to Arbitrage in the Foreign Exchange Market: Evidence from FX Trade Repository Data

Gino Cenedese1, Pasquale Della Corte2, Tianyu Wang2

1Bank of England; 2Imperial College Business School

Discussant(s): Wenxin Du (Federal Reserve Board)

We study the failure of the covered interest rate parity (CIP) condition using transaction level data on over-the-counter foreign exchange swap and forward contracts. Our sample covers more than 17 million transactions recorded between December 2014 and September 2016 for the G10 currency pairs relative to the US dollar. We construct measures of volume for different segments of the market and find that higher trading activity is associated with larger deviations from the CIP condition. We then construct a proxy of interdealer trading activity---Dealer-to-Dealer volume over Dealer-to-Client Volume---and show that CIP deviations become larger when dealers face leverage constraints. In contrast, when leverage constraints are less binding, CIP deviations tend to disappear. Our findings point out that balance sheet costs are a potential explanation of the CIP deviations for major currency pairs.

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