Are Intermediary Constraints Priced?

Violations of no-arbitrage conditions measure the shadow cost of constraints on
intermediaries, and the risk that these constraints tighten is priced. We demonstrate
in an intermediary-based asset pricing model that violations of no-arbitrage such
as covered interest rate parity (CIP) violations, along with intermediary wealth
returns, can be used to price assets. We describe a “forward CIP trading strategy”
that bets on CIP violations becoming smaller, and show that its returns help identify
the price of the risk that the shadow cost of intermediary constraints increases. This
risk contributes substantially to the volatility of the stochastic discount factor, and
appears to be priced consistently in U.S. treasury, emerging market sovereign bond,
and foreign exchange portfolios.