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Three-Point Arbitrage in the FX Market

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Three-Point Arbitrage in the FX Market Three-point arbitrage in the FX market Opportunities for abnormal profits when trading with SEK, NOK and USD Authors: Asal Ghiassee-Tari Fredrik Nilsson Supervisor: Lars Líndbergh Student Umeå School of Business and Economics Spring semester 2014 Master thesis, two-year, 15 hp Abstract With a continuous growing foreign exchange market there is a need for further research in its field as currencies traded have more and more effect on countries’ economies and investor’s portfolios. Although the existing research is well established and updated there is a gap present in the research field when looking at arbitrage in the exchange of two smaller currencies, SEK and NOK against a larger currency, USD. In order to answer the main research question two sub questions have been constructed. The main research question; Is it possible to make three-point arbitrage profits by trading SEK, NOK and USD on a daily basis? This question will be answered by looking at high frequency data from a period of 10 years with the with regards to the Swedish stock markets economic cycles. The usage of quantitative data from Data Stream pushes us towards a deductive approach with an objectivistic standpoint and positivistic view, where the feelings and underlying actions of people will not be studied. Instead the focus lies on testing hypotheses which gives an understanding of the possibility of arbitrage by examining volatility and correlation in the exchange between the three currency pairs. The method used is based on there not being a theory constructed or subjectivity in the analysis, instead with the empirical data the result and analysis adds additional research to the field to lessen the existing gap. A well established view on the market is the theory of Efficient Market Hypothesis (EMH) which states that all information is present in set prices. This would mean that the possibility of arbitrage is non-existing. As this thesis examines the possibility of abnormal profits we had to look at factors that oppose the theory, such as market imperfections. Transaction costs are market imperfections that indicate an opportunity for arbitrage, but also a factor that negates the profits as it may be higher than the profit itself in some cases. Three-point arbitrage is also examined as this is the focus of the study, where the speed of the transaction, size and analytical tools are found to play into the success or failure of the arbitrage, as well as how effective the arbitrageurs are. With the usage of Pearson Product-Moment Correlation (PPMCC) the relationship between the exchange rates and the stock market is examined, as it may have an impact on the arbitrage as well as looking at volatility which is highly present in exchange rates. The volatility compared indicates movement away from equilibrium resulting in arbitrary opportunities. The first sub-question; Are the SEK/USD-SEK/NOK, SEK/USD-USD/NOK and exchange rates perfectly correlated? answers how efficient the market is for the exchange rates. We draw the conclusion that there is a possibility to make risk-free profits by trading the three currencies as the market shows signs of not being efficient. The exchange rates have low correlation no matter the economic cycle we look at and indicate that these are good for a diversified portfolio as it portrays a lower risk. The second sub-question; Does the daily cross-rates differ from the daily real SEK/NOK exchange rates quotes? gives information on if mispricing is present. The real exchange rate and the quoted one do fluctuate, where their spread changes daily indicating a possibility of arbitrage on a daily basis. Our results also show that the opportunity of arbitrage increases during periods of high volatility. The conclusion of the two sub-questions results in the answer of there being a possibility of three-point arbitrage when using SEK, NOK and USD on a daily basis. Table of content Chapter 1 ............................................................................................................................................. 1 1.1 Problem background ................................................................................................................ 1 1.2 Research gap ............................................................................................................................ 3 1.3 Research question, contributions and purpose ......................................................................... 4 1.4 Perspective and target audience ............................................................................................... 6 1.5 Delimitation .............................................................................................................................. 7 Chapter 2 – Theoretical Methodology ................................................................................................ 9 2.1 Choice of subject ...................................................................................................................... 9 2.2 Preconception ........................................................................................................................... 9 2.3 Type of study .......................................................................................................................... 10 2.4 Structure of the research ......................................................................................................... 11 2.5 Research Philosophy .............................................................................................................. 11 2.5.1 Ontology .......................................................................................................................... 12 2.5.2 Epistemology ................................................................................................................... 13 2.6 Research Approach ................................................................................................................ 13 2.7 Research Method .................................................................................................................... 15 2.8 Research strategy ................................................................................................................... 16 2.8.1 Time horizon ................................................................................................................... 18 2.9 Literature and Data source ..................................................................................................... 19 2.10 Reliability, Replicability and Validity.................................................................................. 20 2.11 Research Ethics and Societal Issues ..................................................................................... 22 Chapter 3 – Theoretical Framework .................................................................................................. 25 3.1 Currency trade ........................................................................................................................ 25 3.1.1 Foreign exchange markets and exchange rates ............................................................... 25 3.1.2 Spot rates in foreign exchange markets ........................................................................... 26 3.1.3 Cross rates ....................................................................................................................... 27 3.2 An efficient market................................................................................................................. 27 3.2.1 Efficient market hypothesis and random walk ................................................................ 27 3.2.2 Weak form ....................................................................................................................... 28 3.2.3 Semi-strong form............................................................................................................. 29 3.2.4 Strong form ..................................................................................................................... 29 3.2.5 Efficient market hypothesis presence in smaller markets ............................................... 29 3.2.6 Evidence against random walk and EMH ....................................................................... 30 3.3 Market imperfections ............................................................................................................. 31 3.3.1 Transaction costs ............................................................................................................. 31 3.3.2 Arbitrage ......................................................................................................................... 32 I 3.3.3 Three-point arbitrage ....................................................................................................... 33 Chapter 4 – Practical Methodology ................................................................................................... 35 4.1 Sample Data ........................................................................................................................... 35 4.2 Time Horizon ......................................................................................................................... 35 4.3 Calculations of the fluctuations (returns) ............................................................................... 36 4.4 Calculation of arbitrage .........................................................................................................
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