When an entity taking advantage of two or more markets of a price difference goes for simultaneous purchase and sale of a financial instrument on different markets. This is called Arbitrage. The trader involved in arbitrage makes a profit from the difference in prices at different markets.
In our previous article ‘WHY ARBITRAGE FUNDS RANK HIGH WHEN IT COMES TO SAFETY?‘ we have explained risk-free investment in arbitrage mutual funds where an investor can earn profit without the fear of stock-market risk. In this post, we will discuss Forex arbitrage and interest arbitrage.
Forex markets worldwide are decentralized. A currency trading in one place is somehow being quoted differently from the same currency in another trading location. An arbitrageur is able to spot the discrepancy through automated algorithmic trading, simultaneously buy the lower of the two prices and sell the higher of the two prices, and likely lock in a profit on the divergence.
For a simple understanding let me give the following example.
The exchange rate in London is £82.20 = US $100 while the exchange rate in the U.S. is US $100 = £82. A trader buys in the US market at US $100 = £82.20 and sells in the London market at £82 for the US $100. In this transaction, he makes a profit of £0.20. Thus, when a trader converts the cash in one country, and then into another country in order to maximize the exchange rate would be arbitrage.
Triangular Forex arbitrage:
A triangular arbitrage opportunity is a trading strategy that exploits the arbitrage opportunities that exist among three currencies in a foreign currency exchange. The arbitrage is executed through the consecutive exchange of one currency to another when there are discrepancies in the quoted prices for the given currencies.
Triangular arbitrage can be applied to the three currencies – the US dollar, the euro, and the pound. To execute the triangular arbitrage opportunity, Sam should perform the following transactions:
Illustration:
A forex trader spots the following rates in the forex market
1 GBP= 1.1214Euro
1GBP=1.1926 US$
1Euro 1.07364 USD$
Hence:
He sells $ 990547.14 and gets £830577.85$
He sells £830577.85 and gets €931410
He sells €931410 and gets 999999.0324 USD
In the above transaction, he earns a gross profit of USD 9451
Calculation:
Sell 990547.14 Dollars for British Pounds: $ 990547.14/1.1926=£830577.85
Sell 830577.85 pounds for Dollars:= £830577.85×1.1214=€931410
Sell €931410 for Dollars:€931410x 1.07364= 999999.0324 USD
Profit:999999.0324-990547.14 = 9451 USD
Nowadays, triangular arbitrage opportunities are often exploited by high-frequency traders. Using high-speed algorithms, traders can quickly spot mispricing and immediately execute the necessary transactions. However, the competition in the markets constantly corrects the market inefficiencies and arbitrage opportunities do not last long.
Interest arbitrage: In order to obtain a higher interest yield, the traders in foreign exchange switch to another currency by way of buying a spot and investing the bought currency to get a higher interest yield. The exchange currencies may be from local currency to foreign currency or from foreign currency to local one. This is known as ‘Interest arbitrage’
In the ‘Yen carry’ trade an investor borrows ‘Yen’ at a low-interest rate in Japan and then exchanges it for either U.S. dollars or a currency in a country that pays a high-interest rate on its bonds. In this trade process, they receive high-interest rates on the money invested, but pay low-interest rates on the money borrowed. This is an example of interest arbitrage.
Originally posted on October 17, 2018, edited and reposted on March 19, 2023
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