Price discovery and triangular arbitrage in currency markets

Abstract

Price discovery is the process by which markets incorporate the relevant information to arrive at the efficient price of an asset. We study the price discovery process in JPY/EUR cross-rates and the rates derived from exchanges of JPY/USD and USD/EUR indirectly. The results highlight the role of the USD as a vehicle currency in enhancing price efficiency through the triangular arbitrage. During financial crisis periods, the implied JPY/EUR rates have even more contribution to price discovery than direct rates. We show the dominant price discovery of implied JPY/EUR rates relates to the lower transaction cost. Upon the release of macroeconomic announcements in Japan and Europe zone, the trading cost advantage enhances price discovery of implied rates even more. The more contribution to price discovery of implied rates predicts the higher future volatility of direct JPY/EUR rates, indicating the slower response of direct rates to the information shock and the subsequent adjustment resulting in higher variations in the direct rates.