Triangular Arbitrage in the Foreign Exchange Market: Inefficiencies, Technology, and Investment Opportunities

Triangular Arbitrage in the Foreign Exchange Market: Inefficiencies, Technology, and Investment Opportunities

Triangular Arbitrage in the Foreign Exchange Market: Inefficiencies, Technology, and Investment Opportunities

Triangular Arbitrage in the Foreign Exchange Market: Inefficiencies, Technology, and Investment Opportunities

Synopsis

The major purpose of the book is to illustrate that triangular arbitrage in the foreign exchange market can be profitable. This idea is reinforced by the recent evolution of an independent cross market, and the remarkable developments in telecommunications. The book illustrates how a dealer of Foreign Exchange can apply the "buy low and sell high" rule without taking any risk. The keys to avoid the risk are speed and precision. All the procedures are computerized so that speed and precision problems that are inherent in manual trading are now solved.

Excerpt

In a market where trading never stops, and profitable opportunities may arise at any moment, efficiency is a continuous concern. Given the technological advancements in global telecommunications, many asset markets, especially the currency market, became a single, around-the-clock market, more competitive, more attractive, and easier to enter. The role of efficiency in such an environment is crucial and it raises several important questions. Does the market allow for risk-free profitable opportunities? If it does, how do those opportunities behave over time? This chapter will address those issues, and it will attempt to provide the theoretical basis for evaluating those issues.

Efficiency in the Foreign Exchange Market (FXM) comes in different shapes and forms. It is supported by perfectly competitive conditions that prevail in the market, and the assumption of rational expectations. In this chapter the theory of efficiency of the FXM is examined, within the context of triangular parity, where efficiency comes in the form of consistency in the exchange rates. Consistency within a set of currencies means that the exchange rates are in parity. In other words, they are aligned in a way that no persistent risk free-profits can be made by arbitraging among currencies. Within the context of arbitrage, efficiency is the same as consistency between the prices involved. The criteria for a direct and precise test of triangular parity are developed. That will provide us with a direct and precise test of efficiency, something that was not feasible in the past. The main hypothesis to be tested is the efficient market hypothesis, or simply the consistency hypothesis. The main hypothesis is evaluated in terms of four sub-hypotheses, each one focusing on a different dimension of efficiency.

Throughout the analysis the following exchange rates are introduced: the U.S. dollar ($), the British sterling (£), the Japanese yen (¥), the German mark (DM) . . .

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