Does default risk rule out covered interest arbitrage?

Mampuru, Tebogo

Does default risk rule out covered interest arbitrage?

Thesis / Dissertation

2023

Publisher

University of Cape Town

Department

Department of Finance and Tax

Faculty

Faculty of Commerce

Abstract

This dissertation investigates how the default risk of European banks hampers their ability to exploit the basis in international interest rate markets. One of the reasons deviation from the covered interest parity (CIP) condition persists is the cost borne from the added cost of borrowing due to the default risk of the arbitrageur. Using risk-neutral survival probabilities implied from credit default swap (CDS) data, we determine that when we account for default risk the arbitrage sometimes disappears. It appears that the survival probabilities are relatively low when the CIP basis is high, which is consistent with default risk being a significant obstacle to exploiting the basis. Also, default risk seems to only rule out the basis when the CIP violation is small.

Keywords

European banks

CDS

Reference:

Collections

Masters

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