Academic journal article Economics, Management and Financial Markets

Conditions of Pure Arbitrage Applications: Evidence from Three Currencies

Academic journal article Economics, Management and Financial Markets

Conditions of Pure Arbitrage Applications: Evidence from Three Currencies

Article excerpt

1. Introduction

The "arbitrage paradox," initially identified by Grossman and Stiglitz (1976, 1980), argues that the windows for pure arbitrage appear only when they become the most unanticipated by the currency- and/or credit markets. That is, the general expectations of non-existence for riskless pure arbitrage opportunities, especially when transaction costs are involved, will lead to the investing public's observational negligence and thus the actual occurrence of arbitrage (Akram et al., 2008). Such pure arbitrage opportunities may be rare and short-lived in real financial markets, yet their actual existences are far from negligible for practitioners.

One of the well-discussed pure arbitrage examples is "covered interest arbitrage" (e.g., Madura, 2007), which involves coinstantaneous transactions across the domestic and foreign spot currency markets, the domestic and foreign forward/futures currency markets, in addition to the domestic and foreign credit markets. Presumably, if there are sufficient numbers of arbitrageurs in perfectly competitive cross-country financial markets, the covered interest arbitrage profits, if any, will be quickly eliminated by adjustment of one or more of these exchange and interest rate variables. However, in the actual global financial markets which may be non-perfectly-competitive (with heterogeneous expectations) and/or not strongly efficient in reflecting information (due to various policy regulations and interventions across countries), the potential profits from such arbitrages could still be available with some momentums, which can be identified at least ex-post.

By examining the spot-forward relationship in some specific currency markets and domestic-foreign relationship in corresponding credit markets, the main objectives of this research work are a) to find out the frequency of pure arbitrage conditions; b) to indentify the underlying factors that may lead to the occurrence of pure arbitrage conditions; c) to test the accuracy of the model that we build for predicting the pure arbitrage conditions; and d) to summarize the rules regarding how the changes in exchange rates and interest rates can affect the timings on which the pure arbitrage opportunities occur and end. We focus on analyzing those time series of exchange rate and associated interest rate cross banding over the three currencies (Australian dollar, US dollar and British pound) during the "January 1, 1999-December 31, 2012" periods, and investigate the periods when the pure arbitrage conditions exist with the highest frequencies.

Pure arbitrage aims at achieving profits as much "risk-free" and "frictionless" as possible; therefore its application effectiveness depends on some important market conditions, such as the similarity in economic risk environments across involved countries, and the low level of restrictions in currencyand credit markets. The recent findings vary on the significance of CIRP deviations and the associated arbitrage opportunities across developed coun- tries (e.g., Batten and Szilagyi, 2010) or emerging economies (e.g., Hague, 2010; Skinner and Mason, 2011). However, our empirical research is so far the first known attempt focusing on the currency- and credit-market interactions across three particular countries (Australia, the UK, and the US). They share the same language, largely similar cultures and comparable financial market freedoms, thus they are presumably the most "ideal" for riskless and frictionless pure arbitrage implementations. How effectively the pure arbitrage opportunities, if any, can be identified and captured across these three "Anglo-Saxon Capitalism" economies, should arouse particular interest of research. Such a study can provide updated practical advice to investors and traders who are participating in the international currency and credit markets, especially for the purpose of rebalancing arbitrage model factor weights.

2. Literature Review

Our literature reviews focus on some key areas regarding exchange and credit market conditions, with their influences contributing to the setup process of our research framework:

Covered Interest Rate Parity

Under the covered interest rate parity (CIRP), the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium, with virtually no pure arbitrage opportunities (Madura, 2007). …

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