01-27-2026
Imagine you are a U.S. investor comparing two investment options: a) investing in a U.S. Treasury bill at 5% or b) investing in a U.K. government bill at 3% by converting dollars to pounds and locking in the future exchange rate using a forward contract.
At today's exchange rate of $1.25 per £1 and with the 1‑year forward rate at $1.20 per £1, you weigh the safety of both options. In Path A, you invest $1,000 into a U.S. Treasury bill at 5%. After one year, the bond matures, and you yield $1,000 × 1.05, or $1,050. In Path B, you invest in the U.K. with exchange‑rate protection, converting $1,000 to pounds at $1.25 per £1. With the conversion, you invest £800 at 3%, earning £824 after one year. After you convert the currency back at the locked‑in forward rate of 1.20 (£824 × 1.20), you earn $988.80.
Here’s the hitch: the earnings should have been 1:1 due to a rule known as covered‑interest parity (CIP), basically a “no free money” rule in international finance.
That gap represents an apparent arbitrage opportunity, or "free money," that stands against the CIP that textbooks long taught. It would seem to allow investors to make risk‑free profit by borrowing in one currency, converting it, investing in another country and locking in the future exchange rate. In practice, it is often difficult to take advantage of these opportunities.
But after the 2008 financial crisis, the system changed, notes the Daniels School's Kaushik Vasudevan. Had CIP held, Path A and Path B above should still give the same guaranteed return after accounting for interest rates and the forward exchange rate. Since the financial crisis, CIP deviations have widened and persisted, suggesting something fundamental has changed in how global dollar funding works. Ever since, experts like Assistant Professor of Finance Vasudevan have researched to understand the shift.
Vasudevan's recent paper, "Risk and Specialization in Covered-Interest Arbitrage," coauthored by Daniels School Distinguished Fellow Tobias Moskowitz, Chase P. Ross and Sharon Y. Ross, shows not only that these trades lack parity, but they also aren't "riskless" as textbooks once taught. Researchers used confidential Federal Reserve regulatory data — about 25 trillion dollars in daily bank positions — to open up the “plumbing” of this market and see what banks are actually doing when they deliver dollars via currency swaps, and how their behavior might inform our understanding of textbook pricing laws.
At the core, the paper confirms that banks’ trading activities when they take the other side of customers’ dollar demand are not the type of risk-free arbitrage trades typically assumed in textbooks. In practice, banks hold far fewer maturity-matched safe assets than the textbook trade assumes and instead rely heavily on maturity-mismatched bonds and riskier assets like corporate loans and bonds. That means what looks like a “riskless” trade on a whiteboard is, inside the bank, a bundle of interest-rate, credit and liquidity risks. These risks are embedded into prices, shaping deviations from CIP.
The second key finding regards segmentation and specialization. Rather than one integrated global market where big institutions share risks seamlessly, the authors document concentrated, segmented markets: usually in a given currency and maturity bucket. Effectively, this looks like only a few banks dominating different niches due to expertise and relationships.
“A Swiss bank is going to be much better at doing things with Swiss francs than another institution that doesn’t have the same on‑the‑ground expertise,” says Vasudevan.
So, banks sort into different niche markets where they have informational and relational advantages. At the same time, that structure means “if you want to exchange currency from a specific currency to the USD, there actually might effectively be one or two banks that are going to be taking the other side of that trade,” Vasudevan says. It may give them greater market power over pricing and leave risks less widely shared than textbooks assume.
The question is how much meaningful market power banks have over customers. Pricing may be set by a very small set of intermediaries, rather than by broad competition.
The price a firm pays to swap into dollars depends on numerous frictions that banks on the other sides of the trade face, including balance-sheet space, the availability of appropriate maturity safe bonds, and the risk appetite of a potentially small set of specializing banks operating in that particular currency market. Small pricing gaps can scale into large global funding effects when everyone wants USD, which remains the most in-demand currency.
Like other businesses, banks lean into markets where they have deep relationships, local knowledge and strong track records, and they pull back where they lack expertise. That expertise makes it less risky for them to perform the types of activities required to meet swap demand from customers, for example substituting safe government bonds with riskier corporate bonds. But it also concentrates exposure and can create market power when only one or two substantial counterparties remain.
Vasudevan notes that specialization versus diversification is a universal trade-off. Being a “jack of all trades, master of none” is costly in complex markets, but so is over-concentrating on a single product region or client segment.
To decide where they truly have an edge and where they should diversify, organizations may want to implement frameworks that balance retrospective performance and forward-looking risk assessment, Vasudevan says.
Although the paper is primarily a description of what happens in financial markets, the conversation around it offers broader guidance. Business leaders should treat seemingly “frictionless” markets as networks of specialized firms with constrained balance sheets and imperfect risk-sharing. They should be deliberate about where banks claim expertise, how that specialization is supported (people, data, relationships), and what risks arise if that niche comes under stress. Finally, it behooves policy leaders to avoid rushing to one-size-fits-all fixes — whether regulatory or managerial — without understanding the hidden roles of expertise, incentives and unintended consequences in how markets are structured.
Disclaimer: “The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors.”
