A No-Arbitrage Perspective on Global Arbitrage Opportunities

We revisit covered interest parity (CIP) deviations and other fixed income anomalies using a no-arbitrage model. We show theoretically that (i) CIP violations and non-zero cross-currency basis swap rates imply arbitrage opportunities only under certain strong assumptions, and (ii) that cross-currency basis swap rates are tightly connected to spreads in swap spreads of the corresponding currencies. Empirically, our main departure from existing approaches is that, ex-ante, we are agnostic about the appropriate discount rates for the respective cash flows. We extract stochastic discount factors from each country's interest rate swaps and apply them to value all currency-related instruments. We match observed forward currency premiums and generate time-series patterns and magnitudes of cross-currency basis swap rates that are broadly consistent with the evidence, thereby offering a unifying view of fixed income anomalies. Our model-implied interest rates are explained by a linear combination of Treasury interest rate and credit risk, convenience premium, and interbank risk. Our residual pricing errors line up with measures of intermediary constraints and the expensiveness of the U.S. dollar, lending support to models of intermediary based asset pricing for quantitatively realistic models.