Risk and Specialization in Covered-Interest Arbitrage
Prevailing theories of financial intermediation assume an integrated financial sector with frictionless risk-sharing. However, we identify substantial risk-sharing frictions linked to intermediary specialization using the cross-section of covered-interest parity (CIP) deviations as a laboratory. Obtaining confidential supervisory data covering $25 trillion in daily bank exposures, we document that CIP arbitrage is risky for banks, which take on maturity mismatches and purchase risky assets to hedge their currency exposure from derivatives. These risks lead intermediaries to specialize in markets where they have expertise in managing them. Our results highlight the importance of intermediary specialization and its impact on risk premia.
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