Arbitrage in the foreign exchange market: Turning on the microscope

This journal is about the real-time evidence on the frequency, size, duration and economic
significance of arbitrage opportunities s in the foreign exchange market. From this journal we
can learn that the move itself provides a motivation for a fresh analysis of arbitrage
opportunities because of changes in trading practices and market characteristics induced by
electronic platforms. The data set includes contemporaneous tick quotes of exchange rates and
interest rates that pertain to the most liquid segments of the FX and capital markets. It could
detect the existence and measure the duration of a number of short-lived arbitrage
opportunities only by using a unique data set at tick frequency for quotes of comparable
domestic and foreign interest rates and spot and forward exchange rates. Furthermore, one
must take into account all relevant aspects of the microstructure of the markets in order to
capture the opportunities and transaction costs that market participants face. This paper
investigates empirically the existence of arbitrage and the properties of potential departures
from no-arbitrage conditions using a microstructure perspective. The relevant literature
suggests that CIP arbitrage opportunities do not generally arise in the FX market and mispricing
is negligible when one accounts for estimated transaction costs.

The advantages of this study relative to all previous empirical analyses of arbitrage are our
data set, and a precise account of transaction costs as well as pricing and trading conventions.

Overall, the view of financial markets is, where efficiency is not interpreted as a statement
about prices being correct at each point in time but the notion that in efficiently-functioning
financial markets very short-term arbitrage opportunities can arise and invite traders to exploit
them, which makes it worthwhile to watch the relevant markets. These results, coupled with the
unpredictability of the arbitrage opportunities, imply that a typical researcher in international
macro-finance can safely assume arbitrage-free prices in the FX market when working with daily
or lower frequency data.

RECOMMENDATION

One of the recommendation given by the author is , in order to detect the existence and
measure the duration of a number of short-lived arbitrage opportunities it can be only done by
using a unique data set at tick frequency for quotes of comparable domestic and foreign interest
rates and spot and forward exchange rates.

Source: https://www.cass.city.ac.uk/__data/assets/pdf_file/0009/40689/JIE_2008.pdf