Arbitrage trading in forex explained
Arbitrage represents an opportunity for low-risk profit. However, to make the most of an arbitrage trading strategy, there are various technical points that you should know. Find out more about arbitrage and how it works.
What is arbitrage?
Before talking about arbitrage in forex trading, it is important to define arbitrage in general. Simply put, arbitrage is a form of trading in which a trader seeks to profit from discrepancies in the prices of identical or related financial instruments.
These discrepancies occur when an asset – such as EUR/USD – is being differently priced by multiple financial institutions. This means that arbitrage involves buying an asset at one price from the first financial institution and then almost instantly selling it to a different institution to profit from the difference in quotes.
The speed at which transactions are carried out means that the risk for the trader can be very low. However, there is always some risk with trading, particularly if prices are moving quickly or liquidity is low.
How arbitrage trading works
Arbitrage trading works due to inherent inefficiencies in the financial markets. Supply and demand are the primary driving factors behind the markets, and a change in either of them can affect an asset’s price.
Arbitrage traders seek to exploit momentary glitches in the financial markets. They aim to spot the differences in price that can occur when there are discrepancies in the levels of supply and demand across exchanges. As a result, a trader could realize a quick and low-risk profit.
Traders can use an automated trading system to their advantage as part of an arbitrage trading strategy. Automated trading systems rely on algorithms to spot price discrepancies and, as a result, they enable a trader to jump on an exploit in the markets before it becomes common knowledge and the markets adjust.
Types of arbitrage
There are three main types of forex arbitrage:
- Two-currency arbitrage is the exploitation of the different quotes of two currency pairs instead of the differences in price between two currencies in the same pair
- Covered interest arbitrage is a trading strategy in which a trader exploits the interest rate differential between two countries, while using a forward contract as a hedge to cover their exchange rate risk
- Triangular arbitrage arises from the differences in price between three different currencies and the conversion of one currency into two others before it is converted back into the first currency – hopefully at a profit
We’ll give three examples of arbitrage, each explaining the previous bullet points in greater detail:
Let’s first look at an example of two-currency arbitrage. Most often, currency arbitrage involves trading the same two currencies with two different brokers in order to exploit any difference in price.
As an example of currency arbitrage, let’s suppose that two different banks – bank A and bank B – have set different rates on EUR/USD:
- Bank A is buying one euro at $1.6100 and selling at $1.6200
- Bank B is buying one euro at $1.6300 and selling at $1.6400
In this example, a trader could buy euros from bank A, which is selling at $1.6200, and then immediately sell those euros to bank A, which is buying for $1.6300. If the trader does this with an initial investment of $100,000, they could net a quick profit of $1000.
However, the trader would need to act fast after spotting this discrepancy in pricing because as soon as a few traders notice, the forces of supply and demand will cause the banks to adjust their pricings and the opportunity for arbitrage would be lost.
Covered interest arbitrage
Covered interest arbitrage is a trading strategy in which a trader can exploit the interest rate differential between two currencies. They do this by using a forward contract to control their exposure to risk.
The forward contract enables the trader to lock in an exchange rate in the future, while at the same time buying currency at the spot price in the present.
In a covered interest arbitrage strategy for EUR/USD a trader could do the following:
- Start with a certain amount of US dollars
- Recognize that the interest rate in the eurozone is more favorable than interest rates in the US
- Convert the dollars into euros at the spot price and invest in the eurozone. At the same time, organize a forward contract with a fixed exchange rate on EUR/USD to hedge against any shifts in the exchange rate over the investment period
- Realize the interest rate payments on euros
- Convert your euros back into US dollars at the exchange rate guaranteed by the forward contract
To explain covered interest arbitrage in greater deal, here is a step by step example of how it works:
- Start with $3,000,000
- Identify that the euro currently has an interest rate of 4.8%, compared to the dollar interest rate of 3.4%
- Convert $3,000,000 into euros. At an exchange rate of 1.2890 that would give you €2,327,385
- To protect against exchange rate risk, take out a forward contract that locks in a 1.2845 exchange rate on EUR/USD for a year’s time
- Invest €2,327,385 at 4.8% interest rate for a year to get €111,714 in profit from interest payments, giving you a total of €2,439,099
- Change this back into dollars at the exchange rate guaranteed by your forward contract (1.2845) for $3,133,022. This is more than the $3,102,000 you would have had if you had invested in the US at 3.4% over the year instead
Triangular arbitrage involves a forex trader exchanging three currency pairs – at three different banks – with the hope of realizing a profit through differences in the various prices quoted.
This strategy won’t work if all the currencies are exchanged at the same bank because one bank would ensure that they were running an efficient pricing system in order to cut out any opportunities for arbitrage.
As an example, let’s take three of the most commonly traded forex pairs in the market: EUR/USD, EUR/GBP and GBP/USD. The exchange rate for EUR/USD at ‘bank A’ is currently 1.1500, for EUR/GBP at ‘bank B’ it is 1.2000 and for GBP/USD at ‘bank C’, the exchange rate is 1.2500.
The graphic below highlights the process that a trader would go through in order to carry out a triangular arbitrage forex trade.
In this scenario, a trader could do the following:
- Exchange $1,000,000 for EUR to get €1,150,000 at ‘bank A’ ($1,000,000 multiplied by 1.1500 exchange rate)
- Exchange the €1,150,000 for GBP to get £958,333 at ‘bank B’ (£1,150,000 divided by 1.2000 USD/EUR exchange rate)
- Exchange £958,333 for USD to get $1,197,916 at ‘bank C’ (£958,333 multiplied by 1.2500 USD/GBP exchange rate)
- This would leave the trader with a profit of $197,916 ($1,197,916 minus the initial $1,000,000)
- This is an extreme example, designed to clearly highlight the process through which traders exploit exchange rate differentials by deploying a triangular arbitrage strategy. It also does not account for any transaction costs that might be incurred by transferring currencies three times as part of a triangular arbitrage strategy.
Arbitrage trading summed up
- Arbitrage enables a trader to exploit market inefficiencies to generate a low-risk profit
- Opportunities for arbitrage are usually short lived as the market often balances itself out in terms of buyers and sellers once an inefficiency is found by traders
- Automated trading systems can help a trader to capitalize on profit before the window of arbitrage has closed
- Popular forex arbitrage trading strategies include currency arbitrage, covered interest arbitrage and triangular arbitrage
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