[Summary]Exploitable Arbitrage Opportunities Exist in the Foreign Exchange Market

Exploitable arbitrage opportunities exist in the foreign exchange market

BR Marshall, S Treepongkaruna, M Young - 2007 - wwwdocs.fce.unsw.edu.au

Abstract
Exploitable triangular arbitrage opportunities exist in the foreign exchange market net of
the bid-ask spread. Using binding bid-ask quotes at which trades could occur we show
these opportunities exist over the entire twenty-four hour trading day. The size of these
opportunities is time-varying, decreasing at times when more quotes are coming to the
market and when bid-ask spreads are lower. Even at times of high market activity, the size
of these opportunities appears sufficient to attract arbitrage trades. Our findings support the
Grossman and Stiglitz view that arbitrage opportunities must exist to compensate
arbitrageurs for engaging in this activity.

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the method to detect triangular arbitrage opportunities in this article

1. Record the bid and ask prices of the first currency pair that is quoted.
2. Record the bid and ask prices of the second currency pair that is quoted.
3. Keep updating 1. and/or 2. with the most recent quote until the third currency pair
is quoted.
4. Determine if an arbitrage opportunity exists. In the first instance we check this by
selling currency 1 (e.g. USD/JPY) and buying currency 2 (e.g. EUR/JPY). Our net
position after this trade is short USD / long EUR. We then compare the rate this
EUR/USD purchase was made at to the rate quoted for currency 3 (e.g.
EUR/USD). If the rate is lower we calculate the arbitrage profit by assuming we
close the position out by selling at the currency 3 quote. If the rate is higher
(implying a negative arbitrage profit) we recalculate the profit available by buying
currency 1 and selling currency 2. This means we effectively sell the EUR/USD.
This position is closed out with a purchase at the currency 3 quote. We assume all
purchases are at the ask price and sales are at the bid price.
5. We require the third currency quote to occur within two minutes5 of the first
currency quote to minimize the chance that stale quotes are driving our results.

Result

- Arbitrage Opportunities(January 1 2005 to December 31 2005, Data from EBS)

Panel A

N : number of opportunities

% : profit rate

Panel B

Null hypothesis test for zero profit

a relationship between number of quotes and profit

: arbitrage profit increased when trade activity decresing

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