The arbitrage strategy in foreign exchange trading allows investors to make gains by simultaneously buying and selling the same asset, item, or currency on two different marketplaces.
By using this strategy, traders can gain from pricing changes for the same item across the two areas represented on each side of the transaction.
What is Arbitrage?
Arbitrage is known as buying a security in one market and selling it simultaneously at a higher price in another market. This allows investors to benefit from the temporary difference in cost per share.
By buying a stock in a foreign exchange where the equity share price has not yet been adjusted for the exchange rate, which is constantly fluctuating, traders take advantage of arbitrage possibilities in the stock market. Therefore, the stock’s price on the foreign exchange is undervalued compared to the price on the local exchange, placing the trader to profit from this difference.
Although arbitrage trades appear to be complex to the untrained eye, they are quite simple and thus considered low-risk.
How Does Arbitrage Work?
There shouldn’t be any opportunity for arbitrage in a well-functioning market when stocks, bonds, currencies, and other assets are valued correctly. Market mismatches in terms of price or rate can sometimes result from inefficient global marketplaces. Through a method called “arbitrage,” investors can profit from these inefficiencies and do so.
Arbitrage cannot happen without price differences between financial institutions. Such pricing differences now only last a few milliseconds. It normally doesn’t make sense to use arbitrage strategies unless you have a significant amount to spend because they are often insignificant and also expensive.
How Arbitrage Works (Source: Quora)
Types of Arbitrage
There are three types of Arbitrage:
Triangular
Certain investors have used a “triangular” arbitrage method combining three currencies and banks. You could, for instance, use slight variations in exchange rates to convert US dollars into euros, then convert those into British pounds, and finally back into dollars.
Locational
By engaging in this popular type of arbitrage, a trader might profit from a situation when one bank’s price to purchase a certain currency is higher than another bank’s price to sell that currency.
Let’s imagine that bank A offers a $1.25 exchange rate between the euro and the dollar, meaning that you will need to pay $1.25 to get 1 euro. The exchange rate at bank B is $1. An investor can exchange 1 euro for $1.25 at bank A, then transfer that money to bank B to trade for 1 euro at a 1:1 rate. As such, the investor made a profit of $0.25.
Covered Interest
By using the covered interest-rate arbitrage trading strategy, an investor can use a forward contract to profit from an interest rate difference between two countries and decrease their exposure to exchange rate fluctuations.
Let’s imagine that the British pound has a higher 90-day interest rate than the American dollar. You may borrow dollars and then exchange them for pounds. Then, you would deposit that sum at a higher rate and simultaneously sign a 90-day forward contract that would convert the deposit back into dollars at a predetermined exchange rate when it matured.
You will earn when you settle the forward contract and then pay back the debt in USD.
Takeaways
- Arbitrage allows investors to lock in profits by buying and selling the same asset in two marketplaces.
- Through arbitrage investors can profit from inefficiencies.
- There are three types of arbitrage: triangular, locational, and covered interest.
