07 May 2019
What is Forex Arbitrage?
Forex trading generally involves predicting the direction in which the market is likely to move, with the aim of taking fruitful positions. But there is one other way to seek profit from the market without the need to correctly predict a currency pair’s movement. This strategy is known as forex arbitrage. The concept was formalised by the economists Alexander and Sharpe in the 1990s. Forex arbitrage is the act of simultaneously buying and selling currency in two different markets. Arbitrage, by definition, is a type of trade that helps create potential for profit by exploiting price differences between similar financial instruments in different markets or in different forms. If you start practicing arbitrage, you would be called an “arbitrageur.” Your main aim would be to purchase cheaper assets and, at the same time, sell expensive assets, thereby earning a profit on the price different and without any net cash flow. Theoretically, if there is no cash flow, there should be no risk. But in actual practice, an attempt at forex arbitrage includes both cash flow and risk. Arbitrageurs buy currency pairs so that they can exploit short-term price differences. One thing that makes it hard to find price differences is that prices usually move towards equilibrium across markets. Nevertheless, forex arbitrage can be a useful trading technique, if done right.
Types of Forex ArbitrageForex arbitrage can be undertaken as follows. One trader wants to sell a currency at a lower price than another trader who wishes to buy the same currency. Here, profit can be generated by buying the currency from a seller at a lower price and selling it to the buyer at a higher price. However, there is always a risk of the currency price changing or getting a re-quote before the entire transaction is completed. Forex arbitrage is classified into a number of types, such as:
- Cross-currency transaction: Here, a pair of currencies that do not include the US dollar are traded. Usually, these pairs involve the Japanese Yen as one of the two currencies. Traders look to exploit the price difference between the currency pairs or in cross rates of different currency pairs.
- Currency arbitrage: Here, an alert trader would want to take advantage of the price difference between spreads offered by brokers in order to bring maximum benefit.
- Covered interest rate arbitrages: This involves the use of beneficial interest rate differentials so that investment can be done in a high yielding currency. Then, the exchange risk is hedged by a forward currency contract.
- Uncovered interest rate arbitrage: This is the process of changing a domestic currency with a lower rate to a foreign currency that offers higher interest rates on deposits.
- Spot future arbitrage: Here, one takes a position in a particular currency in the futures and spot markets. For instance, you can buy a currency on the spot market and sell it in the futures market, if you see a profitable pricing discrepancy.