Arbitrage ensures that covered interest parity holds. The condition is central to price foreign exchange forwards and interbank lending rates, and reflects the efficient functioning of markets. Normally, deviations from arbitrage, if any, last seconds and reach a few basis points. But after the Lehman bankruptcy, arbitrage broke down. By replicating exactly two major arbitrage strategies and using high frequency prices from novel datasets, this paper shows that arbitrage profits were large, persisted for months and involved borrowing in dollars. Empirical analysis suggests that insufficient funding liquidity in dollars kept traders from arbitraging away excess profits.
Arbitrage is the glue of financial markets. It links securities through pricing relationships, and allows for the smooth and efficient functioning of markets. But under sufficient pressure, arbitrage can break down. That this glue can, and does, snap underscores the fragility of the financial system and potentially calls for policy action. A proper understanding of when and why arbitrage breaks down is therefore fundamental.
Arbitrage needs capital to operate properly and may be disrupted by lack of it. That is the main suggestion of a vibrant literature currently emerging under the heading of slow moving capital, captured with eloquence in Duffie (2010). But earlier writings already suggest these frictions are of first order importance. That is the case in Shleifer and Vishny (1997) and notably Keynes who remarked, as early as 1923, that “speculation [in the foreign exchange market may be] exceptionally active and all one way. It must be remembered that the floating capital normally available...for the purpose of takingadvantage of moderate arbitrage...is by no means unlimited in amount” and thus excess profits, when they arise, persist until “fresh capital [is drawn] into the arbitrage business” (Keynes, 1923, pp. 129-130).
