DP6878 Arbitrage in the Foreign Exchange Market: Turning on the Microscope

Author(s): Farooq Akram, Dagfinn Rime, Lucio Sarno
Publication Date: June 2008
Keyword(s): arbitrage, covered interest rate parity, exchange rates, foreign exchange microstructure
JEL(s): F31, F41, G14, G15
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6878

This paper provides real-time evidence on the frequency, size, duration and economic significance of arbitrage opportunities in the foreign exchange market. We investigate deviations from the covered interest rate parity (CIP) condition using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency. The analysis unveils that: i) short-lived violations of CIP arise; ii) the size of CIP violations can be economically significant; iii) their duration is, on average, high enough to allow agents to exploit them, but low enough to explain why such opportunities have gone undetected in much previous research using data at lower frequency.