Are Intermediary Constraints Priced?

Abstract

AbstractViolations of no-arbitrage conditions measure the shadow cost of intermediary constraints. Intermediary asset pricing and intertemporal hedging together imply that the risk of these constraints tightening is priced. We describe a “forward CIP trading strategy” that bets on CIP violations shrinking and show that its returns help identify the price of this risk. This strategy yields the highest returns for currency pairs associated with the carry trade. The strategy’s risk substantially contributes to the volatility of the stochastic discount factor, is correlated with both other near-arbitrages and intermediary wealth measures, and appears to be consistently priced across various asset classes.Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.