Limits to arbitrage during the crisis: funding liquidity constraints & covered interest parity
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1 Limits to arbitrage during the crisis: funding liquidity constraints & covered interest parity Tommaso Mancini-Griffoli & Angelo Ranaldo Swissquote Conference 2012 on Liquidity and Systemic Risk EPFL Lausanne, Friday, 9th November 2012 Angelo Ranaldo, s/bf-hsg # 1
2 Research aims To document deviations from the Covered Interest Rate Parity (CIP) during the Crisis To explain them Angelo Ranaldo, s/bf-hsg # 2
3 Main findings Keynes, J. M. (1923): A tract on monetary reform. Floating capital normally available for the purpose of taking advantage of arbitrage profits is by no means unlimited in amount (p. 129) The abnormal discount can only disappear when the high profit of arbitrage between spot and forward has drawn fresh capital into the arbitrage business (p. 130) Angelo Ranaldo, s/bf-hsg # 3
4 Related literature: FX arbitrage FX arbitrage Prachowny (1970), Frenkel and Levich (1975, 1977) CIP: Taylor (1989), Rhee and Chang (1992), Akram, Rime, and Sarno (2008) and Fong, Valente, and Fung (2010) On the crisis: Baba, Packer, and Nagano (2008), Baba and Packer (2009b, 2009a), Coffey, Hrung, and Sarkar (2009), Genberg, Hui, Wong, and Chung (2009) and Jones (2009). Angelo Ranaldo, s/bf-hsg # 4
5 Related literature: limits to arbitrage Limits of arbitrage Surveys: Gromb and Vayanos (2010); Brunnermeier and Oehmke (2012) Funding constraints: e.g. Brunnermeier and Pedersen (2009), Garleanu and Pedersen (2011), Gromb and Vayanos (2002), Kondor (2009) Agency problems: e.g. Shleifer and Vishny (1992, 1997), Allen and Gorton (1993) Heterogeneous beliefs: e.g. Miller (1977), Scheinkman and Xiong (2003) Time horizons: e.g. Dow and Gorton (1994) Moral hazard: e.g. Acharya and Viswanathan (2011) Risk aversion: e.g. Xiong (2001) Slow-Moving Capitals: Duffie (2011) Angelo Ranaldo, s/bf-hsg # 5
6 Related literature: crisis measures Unconventional monetary policies CIP and unconventional monetary policies Angelo Ranaldo, s/bf-hsg # 6
7 CIP arbitrage Angelo Ranaldo, s/bf-hsg # 7
8 How to perform CIP arbitrage Secured arbitrage Unsecured arbitrage Angelo Ranaldo, s/bf-hsg # 8
9 CIP arbitrage: unsecured Lender L Borrower B 1W 1M OIS contracts Spot Forward FX Counterparty Angelo Ranaldo, s/bf-hsg # 9
10 CIP arbitrage: secured Lender L Collateral Cash Cash Collateral Borrower B ON / 1W REPO Hedge fund Spot Forward FX Counterparty Angelo Ranaldo, s/bf-hsg # 10
11 Replicating the CIP arbitrage Our method to compute CIP takes into account: 1. Transaction costs pure profits 2. Synchronicity no time bias 3. Actual prices no mismeasurement 4. Secured money market rates minimum risk z F B t... T 4, t A j, t... T 1 St R, B R, A 1 r r k, t... T Angelo Ranaldo, s/bf-hsg # 11
12 Data Asset Synch Maturity Bid / Ask Source FX spt Snaps / All spot Yes TP / EBS FX fwd Yes, snaps ON-2Y Yes TP OIS Yes, snaps 1W-2Y Yes TP REPO USD Snaps ON-3M Price ICAP REPO EUR All trades ON-1Y Yes EUREX REPO CHF All trades ON-3M Yes EUREX EURUSD, USDJPY, GBPUSD, USDCHF, EURCHF Angelo Ranaldo, s/bf-hsg # 12
13 Documenting CIP deviations Angelo Ranaldo, s/bf-hsg # 13
14 CIP profits: short USD 1M, unsecured Angelo Ranaldo, s/bf-hsg # 14
15 CIP profits: short USD 1M, unsecured Sept-Dec 2008: Huge deleveraging Sept. 2007: Northern Rock collapsed March 2008: Bear Stearns failure Dec. 2007: Window dressing Sept. 2008: Fannie Mea & Freddie Mac under conservatorship Sept. 2008: Lehman B. + Angelo Ranaldo, s/bf-hsg AIG # 15 Aug. 2007: BNP Paribas suspended redemption of 3 funds
16 CIP profits: long USD 1M, unsecured Angelo Ranaldo, s/bf-hsg # 16
17 Non-US FF with aggregate exposure on USD McGuire, P. and G. von Peter: The US dollar shortage in global banking, BIS Quarterly Review, March 2009 Angelo Ranaldo, s/bf-hsg # 17
18 CIP profits: short USD 1M, unsecured June 2010: Greek crisis Winter European sovereign debt crisis Lehman Angelo Ranaldo, s/bf-hsg # 18
19 CIP profits: short EUR 1M, unsecured June 2010: Greek crisis Winter European sovereign debt crisis Lehman Angelo Ranaldo, s/bf-hsg # 19
20 CIP profits: overview June 2010: Greek crisis Winter European sovereign debt crisis Lehman Angelo Ranaldo, s/bf-hsg # 20
21 Takeaways 1. Excess profits are currency-specific 2. Excess profits are directional: only when the USD (EUR) is the funding (investment) currency 3. Same picture for any trading strategy Angelo Ranaldo, s/bf-hsg # 21
22 Explanations Angelo Ranaldo, s/bf-hsg # 22
23 Why? 1. Market illiquidity 2. Funding constraints 3. Risk Angelo Ranaldo, s/bf-hsg # 23
24 Market illiquidity Angelo Ranaldo, s/bf-hsg # 24
25 Market illiquidity Mancini, Ranaldo and Wrampelmeyer (JF, 2012) Angelo Ranaldo, s/bf-hsg # 25
26 Deleveraging Adrian-Shin measure A L St Debts Lt Debts Equity Brunnermeier & Pedersen RFS Angelo Ranaldo, s/bf-hsg # 26
27 Prudential hoarding bank deposits left at the FED NY A St Assets Cash USD Lt Assets L St Debts Lt Debts Equity 27 Angelo Ranaldo, s/bf-hsg # 27
28 Limited capital Pledging better collateral, arbitrage requires less capital to cover margins Garleanu and Pedersen (2011) MeasuredbytheSpread bw REPO GC REPO MBS Higher margins 28 Angelo Ranaldo, s/bf-hsg # 28
29 Risk: 3 elements Roll-over Risk Measured by interest-rate spreads Lender L Trader Borrower B Counterparty Default Risk Measured by CDS banks Spot Forward FX Counterparty Contract Risk Measured by option-implied FX volatility Angelo Ranaldo, s/bf-hsg # 29
30 Empirical analysis Angelo Ranaldo, s/bf-hsg # 30
31 Estimation z ' t z t 1 ' t ' t ' t t Market illiquidity Funding constraints Risk factors 31 Angelo Ranaldo, s/bf-hsg # 31
32 Estimation z ' t z t 1 ' t ' t ' t t Market illiquidity Funding constraints Risk factors Policy measures to relax funding constraints 1. Central bank swaps (FED other CBs) 2. Unconventional facilities Exogenous variables 32 Angelo Ranaldo, s/bf-hsg # 32
33 Results on long EURUSD / shorting USD Market Iliquidity Funding Constraints Central banks swap Reserve credits Liquidity hoarding Deleveraging Limited capital Risk Contract risk Rollover risk Counterparty risk Adj. R Angelo Ranaldo, s/bf-hsg # 33
34 FED measures AMLF Discount Window MBS purchase PDCF CP CB swap lines TAF Total USD Trillion US % 100% 65% 48% 94% 44% 0% 45% FGN % 0% 35% 52% 6% 56% 100% 55% 34 Angelo Ranaldo, s/bf-hsg # 34
35 Additional tests & robustness 1. Panel regressions 2. No endogeneity problems Hausman tests Structural VAR 3. Sub-samples The results are not biased by Lehman 4. Other maturities 5. Other intraday snaps 35 Angelo Ranaldo, s/bf-hsg # 35
36 Conclusion Angelo Ranaldo, s/bf-hsg # 36
37 Conclusion Limits to arbitrage Funding liquidity constraints Unconventional monetary policies 37 Angelo Ranaldo, s/bf-hsg # 37
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