International Arbitrage Premia

We introduce the nonlinear arbitrage correction (NAC) as the residual that renders a linear benchmark model for basic assets arbitrage-free. Return data for several economies reveal that NAC is countercyclical, related to financial uncertainty, and foreign exchange option returns, both in- and out-of-sample. We find that NAC predicts future market dislocations, including covered interest rate parity deviations, particularly out-of-sample. We show that conditional linear asset pricing models perform well on average and during normal times, while they imply larger NAC during crises.