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Does the law of one price hold in international financial markets? Evidence from tick data

This paper investigates the validity of the law of one price (LOP) in international financial markets by examining the frequency, size and duration of inter-market price di erentials for borrowing and lending services (`one-way arbitrage'). 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, we nd that the LOP holds on average, but numerous economically signi cant violations of the LOP arise. The duration of these violations is high enough to make it worth- while searching for one-way arbitrage opportunities in order to minimize borrowing costs and/or maximize earnings on given funds. We also document that such opportunities decline with the pace of the market and increase with market volatility.

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File URL: http://www.norges-bank.no/en/Published/Papers/Working-Papers/2008/WP-200819/
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Paper provided by Norges Bank in its series Working Paper with number 2008/19.

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Length: 43 pages
Date of creation: 03 Nov 2008
Date of revision:
Handle: RePEc:bno:worpap:2008_19
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  1. Taylor, Mark P, 1987. "Covered Interest Parity: A High-Frequency, High-Quality Data Study," Economica, London School of Economics and Political Science, vol. 54(216), pages 429-38, November.
  2. Lucio Sarno, 2005. "Viewpoint: Towards a solution to the puzzles in exchange rate economics: where do we stand?," Canadian Journal of Economics, Canadian Economics Association, vol. 38(3), pages 673-708, August.
  3. Alan M. Taylor, 2000. "Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price," NBER Working Papers 7577, National Bureau of Economic Research, Inc.
  4. Bjonnes, Geir Hoidal & Rime, Dagfinn, 2005. "Dealer behavior and trading systems in foreign exchange markets," Journal of Financial Economics, Elsevier, vol. 75(3), pages 571-605, March.
  5. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
  6. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
  7. Sarno, Lucio & Taylor, Mark P. & Chowdhury, Ibrahim, 2004. "Nonlinear dynamics in deviations from the law of one price: a broad-based empirical study," Journal of International Money and Finance, Elsevier, vol. 23(1), pages 1-25, February.
  8. Richard K. Lyons & Michael J. Moore, 2005. "An Information Approach to International Currencies," NBER Working Papers 11220, National Bureau of Economic Research, Inc.
  9. Deardorff, Alan V, 1979. "One-Way Arbitrage and Its Implications for the Foreign Exchange Markets," Journal of Political Economy, University of Chicago Press, vol. 87(2), pages 351-64, April.
  10. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2006. "Arbitrage in the Foreign Exchange Market: Turning on the Microscope," SIFR Research Report Series 42, Institute for Financial Research.
  11. Kim, Youngsoo & Lee, Bong Soo, 2007. "Limited participation and the closed-end fund discount," Journal of Banking & Finance, Elsevier, vol. 31(2), pages 381-399, February.
  12. Garman, Mark B., 1976. "Market microstructure," Journal of Financial Economics, Elsevier, vol. 3(3), pages 257-275, June.
  13. Nikolaou, Kleopatra, 2008. "The behaviour of the real exchange rate: Evidence from regression quantiles," Journal of Banking & Finance, Elsevier, vol. 32(5), pages 664-679, May.
  14. Sarno, Lucio & Valente, Giorgio, 2006. "Deviations from purchasing power parity under different exchange rate regimes: Do they revert and, if so, how?," Journal of Banking & Finance, Elsevier, vol. 30(11), pages 3147-3169, November.
  15. Mark Hutchinson & Liam Gallagher, 2008. "Simulating convertible bond arbitrage portfolios," Applied Financial Economics, Taylor & Francis Journals, vol. 18(15), pages 1247-1262.
  16. Owen A. Lamont & Richard H. Thaler, 2003. "Anomalies: The Law of One Price in Financial Markets," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 191-202, Fall.
  17. Grossman, Sanford J & Stiglitz, Joseph E, 1976. "Information and Competitive Price Systems," American Economic Review, American Economic Association, vol. 66(2), pages 246-53, May.
  18. Fuertes, Ana-Maria & Thomas, Dylan C., 2006. "Large market shocks and abnormal closed-end-fund price behaviour," Journal of Banking & Finance, Elsevier, vol. 30(9), pages 2517-2535, September.
  19. Callier, Philippe, 1981. "One Way Arbitrage, Foreign Exchange and Securities Markets: A Note," Journal of Finance, American Finance Association, vol. 36(5), pages 1177-86, December.
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