FX Arbitrage and Market Liquidity: Statistical Significance and Economic Value

Wai-Ming Fong, Giorgio Valente () and Joseph K.W. Fung
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Wai-Ming Fong: The Chinese University of Hong Kong
Joseph K.W. Fung: Hong Kong Baptist University, Hong Kong Institute for Monetary Research

No 82008, Working Papers from Hong Kong Institute for Monetary Research

Abstract: This paper studies covered interest parity arbitrage violations in foreign exchange markets and their relationship with market liquidity using a novel and unique dataset of tick-by-tick firm quotes for all financial instruments involved in the arbitrage strategy. The statistical analysis reveals that arbitrage opportunities are larger in size and slower to dissipate when market liquidity is poorer. Furthermore, their economic value is sizable but arbitrage profits only accrue to traders who are able to obtain low trading costs. These findings are consistent with a competitive equilibrium with real frictions when some traders have a comparative advantage in arbitrage trading.

Pages: 36 pages
Date: 2008-04
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Citations: View citations in EconPapers (2)

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