Of course there are transactions costs, and the borrowing rate is different from the lending rate. But there are also lots of smart long-only investors who will chase a few tenths of a percent of completely riskless yield. So, traditionally, covered interest parity held very well.
An update, thanks to "Deviations from Covered Interest Rate Parity" by Wenxin Du, Alexander Tepper, and Adrien Verdelhan. (Wenxin presented the paper at Stanford GSB recently, hence this blog post.)
The covered interest rate parity relationship fell apart in the financial crisis. And that's understandable. To take advantage of it, you first have to ... borrow dollars. Good luck with that in fall 2008. Long-only investors had more important things on their minds than some cockamaime scheme to invest abroad and use forward markets to gain a half percent per year or so on their abundant (ha!) cash balances.
The amazing thing is, the arbitrage spread has not really closed down since the crisis. See the first graph. [graph follows]
|Source: Du, Tepper, and Verhdelhan|
What is going on?