FX Arbitrage and Market Liquidity: Statistical Significance and Economic Value
Journal of Banking and Finance, Vol. 34, No. 5, 2010
Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 08/2008
36 Pages Posted: 9 Jun 2022 Last revised: 6 Sep 2022
Date Written: April 1, 2008
Abstract
This working paper was written by Wai-Ming Fong (The Chinese University of Hong Kong), Giorgio Valente (University of Leicester) and Joseph K. W. Fung (Hong Kong Baptist University).
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.
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