Arbitrage

Rewriting the textbook: covered interest parity

For decades, textbooks on international economics and finance built a part of their scaffolding on the foundation of a relationship called covered interest parity (CIP). CIP postulates that, in a world of free capital flows, currency-hedged returns on equivalent-risk assets will equalize across countries. For example, the return to investing in a 1-year U.S. Treasury bill will equal the return to purchasing euros, investing the proceeds in a 1-year German Government liability, and purchasing a contract guaranteeing the future euro/dollar exchange rate at which the euros will be converted back to dollars a year later. In practice, the CIP relationship was such a reliable feature of international fixed-income markets that for decades one could think of banks operating a nearly costless CIP machine to perform what many viewed as a riskless arbitrage.

Then, one day, the CIP machine broke down. It first stopped working in the Great Financial Crisis (GFC) of 2007-2009, when counterparty and liquidity risks both skyrocketed, raising the possibility of defaults and losses in executing the trades necessary. That is, CIP was not a riskless arbitrage.

As a wave of recent research highlights, the conventional, pre-crisis model of the CIP machine remains impaired even as the counterparty and liquidity risks that characterized the GFC have receded....

 

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Reforming mutual funds: a proposal to improve financial market resilience

U.S. capital markets are the deepest and broadest in the world, fortifying the country’s financial system and making its assets both liquid and attractive. A major part of this capital market advantage is due to the role played by mutual funds, which provide retail investors with a low-cost means of diversifying risk while earning a market return on their savings.

However, a growing class of mutual funds—those that hold mostly illiquid assets—appear to be a potential source of systemic risk. In this post we explain why, and then go on to suggest a change that is simple to implement and might mitigate the problem.

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Should I buy or should I sell?

The U.S. stock market dropped last week, but the S&P 500 index is still 13% above its year-ago level and a whopping 181% above its March 2009 trough. If you are an investor, your goal is to buy low and sell high. Looking at the stock market, what would we do today?  Are prices too high? Are they too low? Or, are they just right?

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Bubble, Bubble, Toil and Trouble: What's a policymaker to do? 

With key central bank policy rates stuck at the zero bound (or below!), investors in Europe, Japan, and the United States are searching for yield under every rock (see, for example, the charts below on S&P500 prices and earnings). That is, they are willing to accept small gains on their investments because they see little risk that their cost of funding will rise significantly for a long time...
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