TESTING FOR ARBITRAGE OPPORTUNITIES WITHIN THE FOREIGN EXCHANGE MARKET TESTIG FOR ARBITRAGE OPPORTUITIES WITHI THE FOREIG EXCHAGE MARKET Imran Hussain An Independent Study Presented to The Graduate School of Bangkok University In Partial Fulfillment Of the Requirement for the Degree Master of Business Administration 2009 © 2009 Imran Hussain All Right Reserved Hussain, Imran. Master of Business Administration, June 2009, Graduate School, Bangkok University Testing For Arbitrage Opportunities within the Foreign Exchange Market (51 pp.) Advisor of Independent Study: Andrew R. Criswell, Ph.D. ABSTRACT This study aims to determine whether or not arbitrage opportunities exist within the retail foreign exchange market and how the number of opportunities compares to those found within the interbank foreign exchange market. The concept of triangular arbitrage is used within this study to identify potential arbitrage opportunities. This study makes use of minute frequency data obtained from a retail foreign exchange broker involving the US dollar, Euro and Japanese Yen. This study covers a one week period from 4th to the 10th of April 2009, over which arbitrage opportunities are tested for using the triangular arbitrage trade strategy. This study also tested to see if triangular parity is a good predictor of future currency movement. This study finds that some arbitrage opportunities do exist within the retail foreign exchange market, however the returns of these opportunities suggests that the retail foreign exchange market falls in line with the efficient market hypothesis. This study finds that arbitrage opportunities in the form of triangular arbitrage are more common within the interbank market than the retail market. This study also finds that triangular parity is not a good predictor of currency movement. v TABLE OF COTETS Page Abstract iv Chapter 1. RESEARCH PROPOSAL 1 1.1 Background & Statement of Problem 1 1.2 Objective of Study 4 1.3 Intention and Reason for Study 5 1.4 Benefits of Research 6 Chapter 2. LITERATURE REVIEW 7 2.1 Introduction 7 2.2 Foreign Exchange Markets 7 2.3 Foreign Exchange Quotes and Currency Valuation 9 2.4 Technology & Market Efficiency 11 2.5 Arbitrage 12 2.6 Different Forms of Foreign Exchange Arbitrage 13 2.7 Triangular Parity 14 2.8 Triangular arbitrage 17 2.9 Trading Platforms & Forex Data Feeds 20 2.10 Alpari & Meta Trader 4 22 Chapter 3. RESEARCH METHODOLOGY 24 3.1 Introduction 24 3.2 Data 24 3.3 Construction of Bid-Ask Quotes 26 3.4 Testing for Triangular arbitrage and Currency movement 26 vi 3.4.1 Triangular Arbitrage 26 3.4.2 Testing for Currency movement using Triangular parity 30 3.5 Hypothesis 31 Chapter 4. DATA ANALYSIS & DISCUSSION 32 4.1 Retail Market Results 32 4.2 Interbank Market Results 34 4.4 Predicting Currency Movement Using Triangular Parity 39 Chapter 5. CONCLUSION AND RECOMMENDATIONS 45 BIBLIOGRAPHY 49 vii LIST OF TABLES Page Table 1. Sample Data 25 Table 2. Bid-Ask Spread Scenario for Retail & Interbank Segment 29 Table 3. Triangular Arbitrage Opportunities within Retail Foreign ExchangeMarke 32 Table 4. Arbitrage Opportunities within Interbank Segment - Scenario 1-3 34 Table 5. Arbitrage Opportunities within Interbank Segment - Scenario 4-5 36 Table 6. Descriptive Stats - Showing Difference Between Predicted & Actual Close Rates 39 Table 7. Descriptive Stats for Currecny Movement 39 viii LIST OF FIGURES Page Figure 1. Chart Showing How Triangular Arbitrage Opportunities Vary As Different Levels of Bid-Ask Spreads are Used 38 Figure 2. Chart Showing the Average Retrun per Dollar Investment as Spreads Increase 38 Figure 3. Chart Showing The Relationship Between The Predicted EUR/JPY Value and The Actual EUR/JPY & The Subsequent Currency Movement 42 Figure 4. Chart Showing The Relationship Between The Predicted EUR/JPY Value and The Actual EUR/USD & The Subsequent Currency Movement 43 Figure 5. Chart Showing The Relationship Between The Predicted EUR/JPY Value and The Actual USD/JPY & The Subsequent Currency Movement 44 1 CHAPTER 1 RESEARCH PROPOSAL 1.1 Background and Statement of Problem The foreign exchange market is considered to be the largest market of any type. According to the Bank for International Settlements (2009) the foreign exchange market is the most actively traded market in the world, with a daily trade volume in excess of $3.2 trillion. The foreign exchange market has no physical location as such instead it is defined by its participants and its three major trading centers situated in London, New York and Tokyo. The foreign exchange market connects all forms of institutions from large investment banks to government and private commercial banks via a network of technology. Not only is the foreign exchange market extremely liquid, it is also considered to be highly efficient and in line with the efficient market hypothesis. Before the establishment of retail foreign exchange brokers such as Oanda Currency Services and The Alpari Group, engaging within foreign exchange trading was an expensive prospect. Foreign exchange trading required one to invest in an expensive electronic platform upon which a number of data feeds could be monitored and traded. Having invested in a trading platform, one would then need to enter within an agreement with foreign exchange brokers or interbank counterparties to get access to the data feed upon which the trading will be conducted. The costs mentioned so far represent only the fixed costs, variable costs would include the bid-ask spreads, commission and trading fees. These variable costs would vary depending on the currency pairs involved and the volume of the trade. This combination of fixed and variable costs made the market inaccessible to the small retail level trader. However 2 over the past decade retail foreign exchange brokers have made it possible for the retail level trader to engage the foreign exchange market using fixed cost free trading solutions. These fixed cost free or minimal fixed cost trading solutions make use of freely available trading platforms in conjunction with retail foreign exchange brokers, such as Oanda Currency Services or The Alpari Group. These retail foreign exchange brokers provide their clients with data feeds free of cost for use in their trading. Though the retail level trading solution being discussed is fixed cost free, the fixed cost do not simply disappear instead they get absorbed within the variable costs. Oanda Currency Services and The Alpari Group claim to charge no commissions or trade fees, this would stipulate that they must be incorporating all of their costs within the bid-ask spreads. If the all the costs associated with running the trading platform, data feeds, commissions and trade fees are incorporated within the bid-ask spreads then one would assume that the spreads of such a solution would be prohibitively high for any arbitrage based trading activity. The foreign exchange market is considered to be in line with the efficient market hypothesis, which would stipulate the absence of any arbitrage opportunities. Numerous studies have been conducted looking for arbitrage opportunities within the foreign exchange market. Studies by Frenkel and Levich (1975 & 1977), Taylor (1987 & 1989), Rhee and Chang (1992), and more recently Batten and Szilagyi (2006) and Akram, Rime, and Sarno (2008) look for arbitrage opportunities in the form of covered interest arbitrage. More recent studies by Aiba, Hatano, Takayasu, Marumo and Shimizu (2002, 2003), Aiba and Hatano (2004), Marshall, Treepongkaruna, and Young (2008), and Fenn, Howison, McDonald, Williams, and Johnson (2009) have 3 used triangular arbitrage to identify positive arbitrage opportunity while making use of high frequency data sets. All of these studies have shown that even after taking into account transaction costs that a number of arbitrage opportunities exist. The findings of these studies indicate that at least on paper using empirical testing, arbitrage opportunities can be found in the foreign exchange market at the interbank level. A point to note is that all of the studies mentioned before were looking for arbitrage opportunities at the interbank level, where the trade sizes would be in the millions. However no study as of yet has looked for arbitrage opportunities at the retail level where the trade sizes are a lot smaller. If arbitrage opportunities have been identified within the interbank segment of the foreign exchange market then it should also be possible to identify arbitrage opportunities within the retail segment of the foreign exchange market. It could be assumed that conducting trades along the lines of triangular arbitrage would not be possible at the retail level as it requires the use of multiple brokers and extremely low bid-ask spreads. Discussions on online trading forum boards focused on retail foreign exchange trading such as Forex TSD Review and Forex Factory suggests that if the brokers bid-ask spreads are larger than 2 pips then 1 achieving profits via triangular arbitrage is not possible . However at the time of writing this study retail level foreign exchange service providers were advertising bid- ask spreads as low as 0.9 pips2 for selected major currency pairs. If retail foreign 1 The mentioned forum boards can be viewed using the following links, Forex TSD Review - http://www.Forex-TSD.com/ and Forex Factory - http://www.forexfactory.com/ (n.d) 2 Information regarding the bid-ask spread was obtained from the Oanda Currency Services website http://fxtrade.oanda.com/ 4 exchange market makers are offering such low bid-ask spreads then it would be worthwhile investigating wheatear or not arbitrage opportunities are also present at the retail level of the foreign exchange market. This study seeks to determine whether or not arbitrage opportunities are present at the retail level when using the bid-ask spreads as provided by a retail level foreign exchange brokers. This study not only looks into arbitrage opportunities at the retail level but also at the interbank level by using a set of assumed bid-ask spread scenarios to emulate the costs that would be faced by a non bank dealer such as hedge fund engaging directly with interbank counterparties.