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  3. 2024
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  5. Asset Pricing: Market Mispricing and Limits to Arbitrage
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Asset Pricing: Market Mispricing and Limits to Arbitrage

Paper Session

Friday, Jan. 5, 2024 8:00 AM - 10:00 AM (CST)

Marriott Rivercenter, Grand Ballroom Salon A
Hosted By: American Finance Association
  • Chair: Christian Opp, University of Rochester

Risk and Segmentation in Covered-Interest Parity Arbitrage

Tobias Moskowitz
,
Yale University
Chase Ross
,
Federal Reserve Board
Sharon Ross
,
Federal Reserve Board
Kaushik Vasudevan
,
Purdue University

Abstract

Prevailing theories of financial intermediation struggle to explain a striking feature of bank-intermediated arbitrages: spreads on these trades exhibit substantial cross-sectional variation in sign and magnitude. We use confidential supervisory data-covering $25 trillion in daily notional exposures on average-to study covered-interest parity (CIP) deviations in currency markets. We uncover three novel forces important for explaining cross-sectional variation in CIP deviations: foreign safe asset scarcity, which makes CIP arbitrage imperfect and risky; market segmentation, with banks specializing in different markets; and concentration of demand. Our findings highlight the presence of risk in ostensibly riskless arbitrage and the importance of segmentation and search frictions in even the most liquid markets.

Pension Fund Flows, Exchange Rates, and Covered Interest Rate Parity

Felipe Aldunate
,
Universidad de los Andes Chile
Zhi Da
,
University of Notre Dame
Borja Larrain
,
Pontifical Catholic University of Chile
Clemens Sialm
,
University of Texas-Austin

Abstract

Frequent, yet uninformed, market timing recommendations by a financial advisory firm generate significant flows for Chilean pension funds. These flows give rise to substantial changes in the Chilean foreign exchange due to the funds' high allocation to international equities. Hedging by local banks propagates the demand fluctuations from the spot to the forward currency market and results in deviations from covered interest rate parity. Using bank balance sheet data, we confirm that banks' risk bearing constraints create limits to arbitrage.

Why is Asset Demand Inelastic?

Carter Davis
,
Indiana University
Mahyar Kargar
,
University of Illinois
Jiacui Li
,
University of Utah

Abstract

In many frictionless asset-pricing models, investor demand curves are virtually flat. Koijen and Yogo (2019), in contrast, estimate surprisingly inelastic demand. In this paper, we identify the source of this discrepancy and show that low demand elasticity estimates for individual stocks are not puzzling if price movements are not entirely associated with short-term discount rate changes. In a standard portfolio choice framework, we show that the demand elasticity is primarily determined by how expected returns impact investor portfolio weights in response to price movements. If prices only drop due to next-period discount rates (as most theoretical models assume), we show that demand elasticity will be high. But, if price movements are not entirely driven by next-period expected returns (as empirical estimates of elasticity measure), demand will be inelastic. Consistent with inelastic demand estimates, we find evidence of weak reversals or momentum at different horizons.

Discussant(s)
William Diamond
,
University of Pennsylvania
Amy Huber
,
University of Pennsylvania
Daniel Neuhann
,
University of Texas
JEL Classifications
  • G1 - General Financial Markets