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Essays on Cross-Currency Arbitrage and Premia


In Chapter I of this dissertation, I show that a no-arbitrage consistent but costly collateral rental yield explains about two-thirds of the apparent standard Covered Interest Rate (CIP) violations. I proxy this yield with the difference between the risk-free and overnight index swap rates between the cross bilateral currencies and apply it to both short and long-term CIP violations. Further, the results suggest an important direct collateral channel through which costly collateralization explains CIP violations, independent of previously documented global risks and intermediary frictions. In Chapter II, I study the relationship between currency crashes and sovereign defaults. Measuring their relationship is notoriously difficult because these are rare disasters. I take a novel approach. Because they reflect the market’s assessment of tail risks, I learn about the risk-neutral distribution of rare currency crashes from prices of far out-of-the-money (FOM) foreign exchange (FX) options and about rare sovereign defaults from prices of credit default swaps (CDS). I find that FOM puts can insure against sovereign credit risk, implying a strong link between currency crashes and sovereign defaults. However, I also find puzzling evidence suggestive of market segmentation, which generates a generous Sharpe ratio in excess of 7.2 when trading between the two markets which disappears during times of crisis. The trade profitability is related to why the same sovereign pays a lower credit interest rate on otherwise equal debt in local currency (LC) versus foreign currency (FC), which is known as the “quanto spread,” while the quanto spread, in turn, is related to a developed currency crash distress measure.

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