[summary]Fact and Fictions in FX Arbitrage Processes

Fact and Fiction in FX Arbitrage Processes

R Cross, V Kozyakin - 2012 - repo.sire.ac.uk

Abstract: The efficient markets hypothesis implies that arbitrage opportunities in markets such as
those for foreign exchange (FX) would be, at most, short-lived. The present paper surveys the frag-
mented nature of FX markets, revealing that information in these markets is also likely to be fragment-
ed. The “quant” workforce in the hedge fund featured in The Fear Index novel by Robert Harris would
have little or no reason for their existence in an EMH world. The four currency combinatorial analysis
of arbitrage sequences contained in Cross, Kozyakin, O’Callaghan, Pokrovskii and Pokrovskiy (2012)
is then considered. Their results suggest that arbitrage processes, rather than being self-extinguishing,
tend to be periodic in nature. This helps explain the fact that arbitrage dealing tends to be endemic in
FX markets.

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1. FX Markets

FX market activity

- UK : 37%  US : 18%  EMU countries :10%  Japan : 6%  Singapore : 5%  Switzerland : 5%  Hong Kong : 5%  Australia : 4%

Account

- USD 85/200, EUR 39/200, JPY 19/200, GBP 13/200

Currency Pair

- EURUSD 28%, USDJPY 14%, GBPUSD 9%, EURJPY 3%, EURGBP 3%, GBPJPY 0.5%

Proportion of FX transactions

- the London-based EBS and Reuters 18.8%

- the US-based Currenex, Hotspot FX and FXall 11.1%

- single-bank ECNs accounting 11.4%

- Most inter-dealer trades executed electronically  18.5%

- non-electronic execution 24.3%

HFT

- trade latency less than a millisecond

- holding periods “typically well under five seconds”

- 24-30% of total spot FX(2010)

2. The EMH and FX Markets

EMH : the efficient markets hypothesis

3 Versions of EMH

- the weak version : information about present and past values -> technical analysts or algorithms

- the semi-strong version : publicly available information -> fundamental analysts, news, order flow information

- the strongversion : privately available information

EMH in FX market

- if markets were informationally efficient, one would expect to observe periods in which transactions volumes vanished towards zero when there is no new information coming on stream

but FX transactions remain substantial during quiescent market conditions.

- macroeconomic “fundamentals” drive exchange rates did not forecast any better than the EMH postulate that the changes are random -Meese and Rogoff (1983)

- exchange rates are close to a random walk and if the “fundamentals” followed an I(1) process and the factor for discounting future fundamentals was close to one - Engel and West (2005)
- order flow information is private / end-user order flow data can explain about 16% of the monthly spot rate variance between the dollar and the euro - Evans and Lyons(2005)

Stop-loss order

-Osler (2005) discovered significant effects of stop-loss order flows on minute-by-minute foreign exchange rate data, because stop loss level is pre-specified.

HFT

-triangular arbitrage opportunities between the dollar, euro, yen, sterling and Swiss franc during two-minute intervals - Marshall, Treepongkaruna and Young (2007) 

: EBS data

: Estimated mean arbitrage profits, net of bid-offer spreads and 0.2 basic point transaction fees, ranged from 2.8 to 3 basis points.

- covered interest arbitrage (CIP) opportunities - Akram, Rime and Sarno (2008) 

: Reuters data

: the CIP no-arbitrage condition -> the forward-spot exchange rate differential matches the interest rate differentials between similar assets with the same maturity

: discovered profitable arbitrage opportunities and that the profit opportunities were large enough and of significantly long duration for traders to have exploited them with profit.

3. The Fear Index

Novel "The Fear Index" (Harris 2011)

- use fear index

- machine-learning algorithmic trading strategy

4. FX Trading Sequences

Arbitrage trades occur sequentially to no arbitrage state not simultaneously - Cross, Kozyakin, O’Callaghan, Pokrovskii and Pokrovskiy (2012)

There are some formulas but I think they don't give any specific insight.

5. Concluding Remarks

the EMH implies that profitable arbitrage opportunities are, at most, short-lived.

The problem here might be that the academic literature has failed to analyse the complexity of the combinations of possible arbitrage sequences in FX market

The combinatorial analysis of such sequences is straightforward in a three-currency world.

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