Deviations from Covered Interest Rate Parity: The Case of British Pound Sterling versus Euro

Abstract

The authors find that the foreign exchange derivatives market for British pound sterling versus euro deviates from the covered interest rate parity (CIP). The resulting arbitrage opportunities seem to be persistent and vary systematically. They are driven not only by Brexit-related politics. The authors find a relation between the cross-currency basis and various factors. Furthermore, they discover nonlinearities that require the application of deep learning methods. The findings are important for arbitrage desks: They show when arbitrage opportunities will become large for international trade, when to look for better alternatives than hedging with forwards, and when corporate treasuries should procure currencies—that are about to become scarce—in advance. <b>TOPICS:</b>Big data/machine learning, currency, simulations <b>Key Findings</b> ▪ We focus on the investigation of deviations from covered interest rate parity on the British pound and the euro and include event-driven factors. ▪ Arbitrage opportunities seem to be persistent and vary systematically. We make the driving factors explicit. ▪ The presence of nonlinearities requires the application of methods from deep learning. It is shown that deep learning adds value. Equipped with better forecasts, arbitrage desks can prepare for days when there are large arbitrage gains. Corporates can punctually adapt their procurement of currencies that are about to become scarce.