In forex trading, currency arbitrage is the act of purchasing a currency in one market and immediately selling it in another market at a higher price; thus, profiting from a temporary difference in prices.
The word arbitrage means riskless profit and refers to the possibility that an investor can simultaneously buy and sell foreign exchange in different markets at guaranteed profits regardless of whether the expected price movement will be favourable or unfavourable.
Making this possible is the existence of different currencies. Currencies are traded on different exchanges worldwide with varying interest rates, inflation rates (i.e., percentage rate by which prices rise each year) and economic growth rates (fore more info, check out saxo bank).
Currency arbitrage as a trading strategy
An example of this would be if a trader bought GBP/JPY from the market at 115 and then sold it at 116. He would have made one extra Yen per pound, which amounts to ¥1 per each £100 traded. If that rate were maintained throughout the whole lot size (in this case, 1 million), he would make a guaranteed ¥10,000 over here.
That’s only an example and only works in theory – perhaps there could be some slippage or commissions involved along with other moving variables. Still, it should give you a good idea of what should happen theoretically.
Foreign exchange rates are constantly changing, so although this might be a good strategy, in theory, the two currencies quickly close to this rate may not exist during the trade. In other words, it’s a theory, and even if you have a 100% chance of success, you could still lose money from slippage or commissions.
Ways to perform currency arbitrage which include:
Spot trading
It simultaneously purchases a currency at one price and sells it immediately at another without holding onto that particular currency for any period. It is quickly done by online forex brokers who can instantly convert currencies while looking for favourable rates on multiple exchanges.
Forward contracts
There is an agreement between two parties to buy or sell an asset at a specific price on a future date. Forward contracts are similar to futures contracts where the only difference is that they’re not exchange-traded, which means they can be traded over-the-counter (OTC) or “off-exchange”.
Swap contracts
Swap contracts are an agreement between two parties to swap cash flows of one currency for another on a specific agreed-upon future date. Swap contracts are also known as foreign exchange swaps. A single rate is determined at the contract’s inception and then exchanged principal is remitted/paid at maturity with interest payments in between.
Benefits associated with currency arbitrage include:
No market risk
It’s vital that any form of trading has no adverse effect on the rest of your portfolio. In most cases, this isn’t easy to achieve with forex trading since currencies can go up and down – but also sideways! Currency arbitrage removes all market risk because you’re constantly exchanging at one rate; it’s not dependent on whether the overall market goes up or down.
No overnight risk
Another benefit of currency arbitrage (in this case, forward contracts) is that there’s no overnight risk since nothing changes hands until maturity. It makes it particularly appealing to institutions that cannot take any risks associated with overnight positions.
Interest-rate differentials between two countries.
A great thing about forwards (which could be considered a form of currency arbitrage ) is that they adjust for interest-rate differentials between two countries. It can be essential when taking into account the impact of compounding, where returns are added to your initial investment, which in turn accrue interest and make your money grow even further.
Spreads on profits
Regarding currency arbitrage, traders may take advantage of market pricing differences by simultaneously buying at one price and selling at another, thus capturing risk-free profit. These profits are obtained through what’s known as “spreads”, whereby two prices are charged for one currency over another, making a spread. The difference or spread represents the trader’s earnings or losses that they realize for carrying out the arbitrage strategy.
