Limits to Arbitrage during the Crisis: Funding Liquidity Constraints and Covered Interest Parity, Swiss National Bank

Arbitrage normally ensures that covered interest parity holds. But after the Lehman bankruptcy, this central condition in finance broke down. By replicating two major arbitrage strategies using high fre-quency prices from novel datasets, this paper shows that arbitrage profits were large, persisted for months, involved borrowing dollars, arose independently of whether or not loans were secured, and waned as dollar liquidity was provided by central banks. Empirical analysis suggests that hoarding of funding liquidity in dollars and limited cap-ital to pledge for funding kept traders from arbitraging away excess profits. Contract risk further amplified these profits