Spot foreign exchange market and time series

TL;DR

This paper introduces a novel algorithm based on the non-arbitrage principle to accurately estimate real prices in the foreign exchange market, revealing that previous methods may produce misleading correlations and information measures.

Contribution

The authors propose a new non-arbitrage-based algorithm for defining real prices, improving the analysis of high-frequency FX data by removing spurious correlations.

Findings

Returns are shown to be i.i.d. after applying the new price definition.

Spurious short-term covariances are eliminated with the new method.

Apparent information content disappears when using the proposed approach.

Abstract

We investigate high frequency price dynamics in foreign exchange market using data from Reuters information system (the dataset has been provided to us by Ols en & Associates). In our analysis we show that a na\"ive approach to the definition of price (for example using the spot midprice) may lead to wrong conclusions on price behavior as for example the presence of short term covariances for returns. For this purpose we introduce an algorithm which only uses the non arbitrage principle to estimate real prices from the spot ones. The new definition leads to returns which are i.i.d. variables and therefore are not affected by spurious correlations. Furthermore, any apparent information (defined by using Shannon entropy) contained in the data disappears.