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

Author(s): Qaisar 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: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6878.asp.asp

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.