Arbitraging is a process of gaining profit from an advantageous price difference of an underlying in two or more markets. Traders engage in arbitraging are called arbitrageurs. They would purchase an asset at a lower price and simultaneously sell at a higher value in a different market, in between gaining from the price difference arising from market inefficiency. In an ideal situation, arbitraging shouldn’t involve any capital or risk, but in reality, it involves both.
Risk-free Arbitrating; A Result of Market Inefficiency?
The price difference between markets is a result of market inefficiency. But, according to the Efficient Market Hypothesis developed by economist Eugene Fama, in an ideal condition, all active traders and participants in the market will process available price information to bring the market to equilibrium. It means there is no place for price disparities between markets.
However, in reality, market doesn’t always operate efficiently. Meaning, the flow of information isn’t instantaneous always in all parts of the world. As a result, asymmetric information distribution happens between buyers and sellers, creating arbitraging opportunities. The first person to identify such disparity can buy the asset at a lower price in one market while selling it in another market at a higher price.
One such example of market underperformance is when the seller’s asking price is less than the buyer’s bid price, creating a ‘negative spread’. If it happens then, traders can quickly trade into it for profit.
This is apparently a risk-free situation that makes arbitraging possible. But in reality, no trade is entirely risk-free. Arbitrageurs face ‘execution risk’, which is a situation of slippage or price requote that can make the trade less profitable or turn it into a loss.
Forex arbitrage opportunities occur because the forex market is decentralised. As a result, situations like negative spread appears under certain circumstances. Price of one currency can be different in two markets, allowing arbitrageurs to purchase low and sell at a high price, locking a profit in doing so.
Let’s discuss with an example.
A bank in London quotes currency pair EUR/INR 86:40, and a bank India quotes the same pair 86.94. A trader aware of this disparity can open an arbitrage trade to gain from the price divergence.
Forex arbitraging can take many forms, but the essence remains the same. Forex arbitrageurs try to gain from price disparities occurring in different markets at the same time. Types of forex arbitrage include,
– Currency arbitraging is a method of gaining from the difference in quoted price than movements in the exchange rates
– Cross-currency exchange takes place when two or more foreign currencies trade without the US dollar as the base currency. An arbitraging opportunity occurs from the divergence in the quoted price of different currencies or currency pair
– Traders also try to exploit the difference in interest rates. In covered interest rate arbitrage, the traders invest in higher-yielding currency and cover the exchange risk with a forward currency contract
– The opposite of covered interest rate arbitrage is, uncovered interest rate arbitrage, which involves exchanging the domestic currency for a foreign currency that offers a higher rate of return on deposits
– Spot-future arbitrage opportunity involves buying currency at the spot market and selling the same in the future market simultaneously if there is a favourable price difference
We have discussed these variants with little more detail in the section below.
Forex Arbitraging Strategies
In forex trading, traders adopt various strategies to enhance their chance of profit. They look for the price difference between different combinations of trading instruments. Other types of forex arbitrage strategy involve the following.
A variation of negative spread strategy involving three or more currencies is called triangular arbitrage. Traders try to spot a currency that is overvalued against one currency and undervalued relative to another.
One common example of triangular negative spread could be EUR/USD, USD/JPY, and EUR/JPY.
We have a separate article dedicated to triangular arbitrage.
Interest Rate Arbitrage
Interest rate arbitrage is also called a carry trade. Traders sell the currency with the lower interest rate and purchase a currency that offers a higher interest rate. When he reverses the currency later, he gains from the interest rate difference.
This strategy involves an inherent risk of time period. By the time the trader reverses his position, the currency rate and even interest rate can change.
We have discussed sport-future trading strategy separately in Arbitrage Opportunity article.
This additional form of forex arbitrage involves buying an asset at the current market and selling or short the same in the futures market. This strategy is also called cash and carry trade.
In reverse cash and carry trade, traders short in the spot market and opens a long position in the futures market.
Traders using statistical arbitrage assumes that an overvalued currency and an undervalued currency would eventually adjust to the mean. To base their theory, they look into strong historical data of correlation between the currencies. The traders prepare separate baskets of overvalued currencies and undervalued currencies, sell the overvalued basked and purchase the undervalued basket.
Challenges of Forex Arbitrage
Forex arbitrage isn’t free from challenges. The quick market correction, rapid execution, and insufficient information are few of the challenges faced by forex arbitrageurs.
Arbitraging is assumed to be risk-free, but in real-life, arbitrageurs face challenges of price slippage, market reversal, and such. Forming a strategy is only half the battle. Traders face significantly high execution risk.
In the forex arbitrage market, arbitraging opportunities arise and disappear quite fast, lasting only for a few milliseconds or seconds. Traders need to be quite fast on the trigger to capitalise on such opportunities.
Another challenge encountered by traders is the market mechanism of correcting itself. It occurs when too many traders try to execute their arbitraging strategy, eventually narrowing down the price gap so that the trade no longer remains profitable. Because of this corrective mechanism, overvalued and undervalued currencies eventually converge at the mean. It makes forex arbitraging a game of ‘fastest finger first’, meaning you will have to rely on real-time price feed and automated trading platform.
Arbitraging opportunities arise in the forex market, but profitability erodes with time as the number of players increases. Secondly, profiting from arbitraging require both advanced trading software and trading in large volume, which makes it viable only for institutional players. However, if you want to learn more about forex trading, having a fair idea of forex arbitrage strategy will help you read the market better. And, to capitalise from arbitraging, you can invest in arbitraging funds of mutual funds.