Bid-offer Spread Research Articles

The effect of the new risk-based capital requirements on the market for swaps

The new risk-based capital requirements for banks cover swap agreements as well as the normal on-balancesheet items. The capital calculation is based on a fixed small percentage plus the current market value of the swap, if it is positive. Using option valuation methodology, anticipated capital requirements over the life of a swap are calculated. These requirements are compared to cushions that banks might want to hold against the risks of above average loss rates. For interest rate swaps, the cost of the capital requirements is small, amounting to about 1 bp/year on a swap; in a matched pair, this would amount to 2 bp in the bid-offer spread. On currency swaps, the cost of the capital requirements appears to be much more substantial, closer to 4 bp per year on a swap. In a matched pair, the excess of the capital requirements over desired cushion could amount to 7 bp in the bid offer spread.

Covered Interest Arbitrage and Market Turbulence

The covered interest parity theorem states that the covered interest differential between two similar assets denominated in different currencies should be zero. This paper utilizes high-quality data recorded by the dealers at the Bank of England to test covered interest parity during certain historical periods in which there is known to have been turbulence, as well as during a relatively calm, control period. The data is high-frequency and allowance is made for the bid-offer spread, brokerage costs, and other considerations. The results have three main implications. Firstly, profitable arbitrage opportunities do occasionally occur and sometimes persist during turbulent periods. Secondly, the degree of efficiency of the relevant markets appears to have increased over time. Thirdly, there appears to be a maturity effect whereby the existence and size of profitable arbitrage opportunities appear to be positive functions of the length of maturity. A rationalization of this phenomenon is offered in terms of the existence of credit limits. Copyright 1989 by Royal Economic Society.