Triangular arbitrage: Difference between revisions

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Research examining high-frequency exchange rate data has found that [[mispricing]]s do occur in the foreign exchange market such that executable triangular arbitrage opportunities appear possible.<ref name="Fenn et al. 2009">{{Cite journal | title = The Mirage of Triangular Arbitrage in the Spot Foreign Exchange Market | journal = International Journal of Theoretical and Applied Finance | volume = 12 | issue = 8 | date = 2009 | pages = 1105-1123 | author = Fenn, Daniel J. | author2 = Howison, Sam D. | author3 = McDonald, Mark | author4 = Williams, Stacy | author5 = Johnson, Neil F. | url = http://www.worldscinet.com/ijtaf/12/1208/S0219024909005609.html | accessdate = 2011-07-06}}</ref> In observations of triangular arbitrage, the constituent exchange rates have exhibited strong [[correlation]].<ref name="Aiba et al. 2002" /> A study examining exchange rate data provided by [[HSBC Bank (Europe)|HSBC Bank]] for the [[Japanese yen]] (JPY) and the [[Swiss franc]] (CHF) found that although a limited number of arbitrage opportunities appeared to exist for as many as 100 seconds, 95% of them lasted for 5 seconds or less, and 60% lasted for 1 second or less. Further, most arbitrage opportunities were found to have small magnitudes, with 94% of JPY and CHF opportunities existing at a difference of 1 [[basis point]], which translates into a potential arbitrage profit of $100 USD per $1 million USD transacted.<ref name="Fenn et al. 2009" />

Tests for [[seasonality]] in the amount and duration of triangular arbitrage opportunities have shown that incidence of arbitrage opportunities and mean duration is consistent from day to day. However, significant variations have been identified during different times of day. Transactions involving the JPY and CHF have demonstrated a smaller number of opportunities and long average duration during 10:00am and 1:00am [[UTC]], contrasted with a greater number of opportunities and short average duration during 1:00pm and 4:00pm UTC. Such variations in incidence and duration of arbitrage opportunities can be explained by variations in [[market liquidity]] during the trading day. For example, the foreign exchange market is found to be most liquid for Asia during 12:00am and 10:00am UTC, for Europe during 7:00am and 5:00pm UTC, and for America during 1:00pm and 11:00pm UTC. The overall foreign exchange market is most liquid during 8:00am and 4:00pm UTC, and the least liquid during 10:00pm and 1:00am UTC. The periods of highest liquidity correspond with the periods of greatest incidence of opportunities for triangular arbitrage. This correspondence is substantiated by the observation of narrower bid-ask spreads during periods of high liquidity, resulting in a greater potential for mispricings and therefore arbitrage opportunities. However, market forces are driven to correct for mispricings due to a high frequency of trades that will trade away fleeting arbitrage opportunities. <ref name="Fenn et al. 2009" />

There are variations in the number of triangular arbitrage opportunities that occur during different hours of the 24 hour foreign exchange trading day. Perhaps slightly counter-intuitively, more triangular arbitrage opportunities arise during hours when [[market liquidity]] is at its highest; for example, from about 8-10 AM GMT when both Asian and European foreign exchange traders are active, and from 2-4 PM GMT when both European and American traders are active. During more liquid periods, triangular arbitrage opportunities also tend to exist for shorter durations than during less liquid periods. The reason for these differences is that in liquid periods the bid-ask spread is narrower and prices move around at a higher frequency due to the large volume of trading. This results in more price misalignments and thus more potential arbitrages. The high trade frequency, however, also ensures that the mispricings are quickly traded away and thus that any arbitrage opportunities are short-lived.

Researchers have shown a decrease in the incidence of triangular arbitrage opportunities from 2003 to 2005 for the Japanese yen and Swiss franc and have attributed the decrease to broader adoption of electronic trading platforms and trading algorithms during the same period. Such electronic systems have enabled traders to trade rapidly and react hastily to changes in price. The speed gained from these technologies improved trading efficiency and the correction of mispricings, allowing for less incidence of triangular arbitrage opportunities.<ref name="Fenn et al. 2009" />