Fact and fictions in FX arbitrage processes

Abstract

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 fragmented nature of FX markets, revealing that information in these markets is also likely to be fragmented. 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 [1] 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. IntroductionAn arbitrage operation involves taking advantage of discrepancies in the prices at which a particular good or asset can be bought or sold, such operations being distinct from speculation in that they involve minimal risk or capital exposure. In the economics and finance literature the "law of one price" postulates that the exploitation of opportunities to profit from arbitrage, if buying prices are lower than selling prices, will lead goods or assets that are in some sense "identical" to have the same price.The present paper focuses on arbitrage operations in foreign exchange (FX) markets. The Bank for International Settlements [2, p. 5] offers a useful distinction between different arbitrage strategies in FX markets. Classical arbitrage exploits differences between quoted exchange rates and the exchange rates implied by no-arbitrage conditions, such as that cross-exchange rates are consistent with the exchange rates for currency pairs. Latency arbitrage takes advantage of time lags between market-moving trades being initiated and market-makers updating their FX price quotes. Liquidity imbalance strategies aim to detect order book imbalances for currency pairs and pricing discrepancies between different trading platforms. Complex event processing aims to exploit properties of foreign exchange rates such as momentum, mean-reversion, correlation with other exchange rates or reaction to news releases. The present paper focuses on classical arbitrage strategies.Section 2 of this paper considers the institutional context in which FX arbitrage strategies can be executed. In contrast to the textbook fiction of a single FX market, there are a variety of FX trading platforms distinguished not only by geographical location and time zone but also by the means by which transactions are executed. Electronic FX trading platforms have grown in importance in the last decade, but a substantial proportion of transactions are still conducted