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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

Decomposing Deviations from Covered-Interest Parity

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

Abstract

Prevailing theories of financial intermediation face a challenge in explaining a striking feature of bank-intermediated arbitrage trades: that spreads on these trades exhibit substantial cross-sectional variation in sign and magnitude. We use confidential supervisory data - covering more than $25 trillion in daily notional exposures on average - to study covered-interest parity (CIP) deviations in currency markets. We uncover that three novel forces are important for explaining cross-sectional variation in CIP deviations: foreign safe asset scarcity, which makes CIP arbitrage risky; market segmentation, with banks specializing in different markets; and concentration of demand. Our findings highlight the importance of safe assets and investor composition in understanding intermediaries' impact on asset prices.

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, fund flows in Chilean pension plans generate substantial trading in currency markets due to the high allocation to international securities. These non-fundamental flows have a significant impact on the Chilean peso, which is estimated to have a relatively low price elasticity of 0.81. Hedging by the banking sector propagates the price pressure to currency forward markets and results in violations of the covered interest rate parity. Using trading data and bank balance sheet data, we confirm that regulatory requirements and banks' risk bearing constraints create limits of 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