Collateral-Adjusted CIP Arbitrages

I show that an important no-arbitrage consistent but costly collateral rental yield contributes to about two-thirds of the standard CIP violations. I measure this yield using two approaches applied to short- and long-term CIP horizons. First, I assume that the yield is observable and proxy it with the difference between risk-free and overnight index swap rates between bilateral currencies. Second, I assume that the yield is unobservable and generate it using a model incorporating collateralization. Further, this yield appears to be related to global risks and intermediaries’ frictions pointing to an important collateral transmission channel contributing to standard CIP violations