Cointegration Analysis of Liquidity Dynamics: Optimizing Trading Efficiency in the Foreign Exchange Market

Abstract

While recognized as the most liquid market globally, the foreign exchange market encounters a significant variance in liquidity levels primarily due to the dominance of major currency pairs such EUR/USD and USD/JPY. This presents an opportunity for algorithmic trading to exploit potential pricing inefficiencies that arises from the disparity in liquidity between less traded currencies. This research implements several cointegration methods to identify currency pairs with significant long-term relationships and pairs trading strategy to determine its profitability, examining datasets that encompass both end-of-day spot rates and minute-to-minute intraday data. The analysis reveals that the most substantial profits can be made with currencies that exhibit a level of liquidity that is not considered the most liquid nor the least liquid. These currencies allow traders to exploit market inefficiencies, but also ensure that there is a healthy amount of competition that will allow prices to converge towards equilibrium. The absence of US dollar representation within the top profitable currency groups reinforces that a moderate level of liquidity perfectly balances market inefficiencies and broader market consensus. The minute-to-minute intraday dataset yielded less definitive results, possibly suggesting that alternative methods to explore currency relationships may be necessary. However, the findings in general do suggest that there is great potential for profitable trading strategies that take advantage of the differences in liquidity within the foreign exchange market.