I am currently attempting to calculate historical deviations from covered interest rate parity between 2013 and 2018. I recently read that:
"Unlike the interbank spot market, in the interbank forward market, every currency is quoted always against USD (except for EUR/GBP)"
Accordingly, my concern stems from possible deviations of directly quoted exchange rates from their cross rates with a common currency. What I am referring to here is what textbooks use as the classical example of triangular currency arbitrage.My question, therefore, is whether it is possible that said potential mispriced rates could influence the deviations I am planning to calculate?
Example of a what I mean by triangular cross currency arbitrage:
The two indirect quotes being €0.8778/\$ and €1.4373/Pound. Then the cross rate refers to 1.4373 / 0.8778 = \$1.6355/Pound. Assuming 3 exchange rates above and the indirect exchange rate of $/Pound: 1.6365, an investor endowed with 1.000.000 Pound could earn a risk free profit by: first exchanging his money for \$1.636.500 then exchange this for Euros using €0.8788/\$ and obtain €1.438.156 The final step is then to exchange back to Pound from Euro € 1.4373/Pound, which leaves the investor with 1.000.596 Pound and therefore a riskless profit of 596 Pounds
Example of what I mean by triangulating a swap:
To calculate a CHF/JPY swap, a forward trader must calculate each leg of the swap by triangulating USD/CHF and USD/JPY outright rates. The CHF/JPY spot rate is then subtracted from the resultant CHF/JPY outright rates to give CHF/JPY forward points.
Whereas the second example can also be found at the page linked above.