IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/18541.html
   My bibliography  Save this paper

Free Lunch! Arbitrage Opportunities in the Foreign Exchange Markets

Author

Listed:
  • Takatoshi Ito
  • Kenta Yamada
  • Misako Takayasu
  • Hideki Takayasu

Abstract

Using the "firm" quotes obtained from the tick-by-tick EBS (electronic broking system that is a major trading platform for foreign exchanges) data, it is found that risk-free arbitrage opportunities--free lunch--do occur in the foreign exchange markets, but it typically last only a few seconds. "Free lunch" is in the form of (a) negative spreads in a currency pair and (b) triangular arbitrage relationship involving three currency pairs. The latter occur much more often than the former. Such arbitrage opportunities tend to occur when the markets are active and volatile. Over the 12-year, tick-data samples, the number of free lunch opportunities has dramatically declined and the probability of the opportunities disappearing within one second has steadily increased. The size of expected profits is higher than transaction costs; trades that simultaneously take place on both sides of ask and bid (or three currency trades in case of triangular arbitrage) occur more often when free lunch appeared one second earlier than otherwise, suggesting that free lunch opportunities are actively taken. The probability of its disappearance within one second was less than 50% in 1999, but increased to about 90% by 2009. Less frequent occurrence and quicker disappearance in recent years are attributable to changes in trading microstructure: an introduction and proliferation of the Primary Customer system (weaker banks can use stronger banks' credit lines) and of direct connection of traders' programmed computers to the EBS computer.

Suggested Citation

  • Takatoshi Ito & Kenta Yamada & Misako Takayasu & Hideki Takayasu, 2012. "Free Lunch! Arbitrage Opportunities in the Foreign Exchange Markets," NBER Working Papers 18541, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:18541
    Note: AP IFM
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w18541.pdf
    Download Restriction: no

    References listed on IDEAS

    as
    1. Aiba, Yukihiro & Hatano, Naomichi, 2006. "A microscopic model of triangular arbitrage," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 371(2), pages 572-584.
    2. Ito, Takatoshi & Hashimoto, Yuko, 2006. "Intraday seasonality in activities of the foreign exchange markets: Evidence from the electronic broking system," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 637-664, December.
    3. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
    4. Goodhart, Charles A. E. & Payne, Richard G., 1996. "Microstructural dynamics in a foreign exchange electronic broking system," Journal of International Money and Finance, Elsevier, vol. 15(6), pages 829-852, December.
    5. Berger, David W. & Chaboud, Alain P. & Chernenko, Sergey V. & Howorka, Edward & Wright, Jonathan H., 2008. "Order flow and exchange rate dynamics in electronic brokerage system data," Journal of International Economics, Elsevier, vol. 75(1), pages 93-109, May.
    6. Y. Aiba & N. Hatano, 2006. "A microscopic model of triangular arbitrage," Papers physics/0602171, arXiv.org.
    7. Charles Goodhart & Takatoshi Ito & Richard Payne, 1996. "One Day in June 1993: A Study of the Working of the Reuters 2000-2 Electronic Foreign Exchange Trading System," NBER Chapters,in: The Microstructure of Foreign Exchange Markets, pages 107-182 National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Alasdair Brown, 2013. "Information Acquisition in Ostensibly Efficient Markets," University of East Anglia Applied and Financial Economics Working Paper Series 043, School of Economics, University of East Anglia, Norwich, UK..
    2. Takatoshi Ito & Masahiro Yamada, 2015. "High-frequency, Algorithmic Spillovers Between NASDAQ and Forex," NBER Working Papers 21122, National Bureau of Economic Research, Inc.

    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:18541. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (). General contact details of provider: http://edirc.repec.org/data/nberrus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.