Triangular arbitrage as a measure of efficiency in the foreign exchange market

Abstract

This paper uses the principle of triangular arbitrage to measure the efficiency with which information is disseminated across foreign exchange markets. Three dimensions of efficiency, namely profitability, persistence and stability of the expected returns, have been identified as suitable measures and evaluated quantitatively to determine the validity of the semi-strong form of market efficiency proposed by Fama (1970). Using published data from a New York Stock Exchange listed foreign exchange trading firm, the price quotes were pre-processed and evaluated quantitatively for statistical relevance, using appropriate hypotheses and parametric approaches to data analysis. The key finding of this study is that although there were instances where prices deviated from triangular parity, the frequency was statistically insignificant and does not represent generalised and on-going inefficiency in the market. When taking a holistic view of profitability, persistence and stability of the expected returns, the foreign exchange market is efficient; offering insufficient opportunity to generate excess economic returns arising from an informational advantage in any one market.