Millions of traders participate in financial markets across the world every day to earn a return on their investments. The financial markets offer various avenues of making gains. One can buy a security in the morning and sell by noon in an intraday trade. Similarly, an individual with a long-term investment horizon can buy and hold security for several months or years to multiply his/her investment. The listing of a security on multiple exchanges or the trade of a commodity in multiple markets at the same time gives rise to a unique form of trading opportunity, known as arbitrage.
What is international arbitrage?
International arbitrage is the act of buying and selling the same quantity of an asset in two different markets simultaneously. International arbitrage works on the principle of price differential created due to the inefficiencies of the market. International arbitrage entails a trader buying a security from a market at a lower price and sells a similar quantity of security in another market at a higher price to earn a riskless gain. If both the markets are in the same country, it would be called a simple arbitrage trade, but as per international arbitrage definition, both the markets should be in different countries. International arbitrage opportunities are not very common as price differentials reach an equilibrium as soon as they are spotted. If there is a price equilibrium in the market, there will be no space for international arbitrage. The most common types of international arbitrage trades are the buying and selling of International Depository Receipts (IDR), currencies and the same stock registered in two different countries.
Example of international arbitrage
Let us try to understand what is international arbitrage? Suppose the shares of company XYZ are listed on both the National Stock Exchange and the New York Stock Exchange. The shares of XYZ are trading at Rs 500 on the NSE. However, on the NYSE, the shares are trading at $10.5 per share. Let us assume the US$/INR exchange rate is Rs 50, which means 1US$ = Rs 50. At the prevailing exchange rate, the price of the shares on NYSE in INR will be equal to Rs 525. In such circumstances, an investor can simultaneously buy shares of XYZ on NSE and sell on NYSE to earn a profit of Rs 25 per share. However, in real life, the difference is very small and one has to ensure that a favourable exchange rate holds for some time. While opting for international arbitrage, one should take the transaction cost into consideration. High transaction costs can neutralise the gains from arbitrage.
Types of international arbitrage
There are several types of international arbitrage. The three major types of international arbitrage are covered interest arbitrage, two-point arbitrage and triangular arbitrage.
Covered interest arbitrage: When a trader uses a forward contract to hedge against the exchange rate risk while investing in a higher-yielding currency, it is known as covered interest arbitrage. In a covered interest arbitrage, the word ‘cover’ means to hedge against fluctuations in the exchange rate and ‘interest arbitrage’ means to take advantage of an interest rate differential. Covered interest arbitrage is complex trading manoeuvres and requires sophisticated setups.
Two-point arbitrage: A two-point arbitrage is a simple trading technique where a trader buys a security in one market and sells it at a higher price in a geographically different market. According to the dominant economic theory, the exchange rate of a currency should be the same all across the world. But due to certain factors like difference in time zones and lag in the exchange rate, a price differential gets created. To take advantage of the situation, a trader can buy the currency in the market where it is priced lower and sell in a market where the currency is priced higher. A gain can be made only if the exchange rate is higher than the transaction cost.
Triangular arbitrage: A triangular arbitrage or three-point arbitrage is an advanced version of the two-point arbitrage. It involved three currencies or securities instead of two. A triangular arbitrage opportunity arises when there is a mismatch in the exchange rate of three different currencies. In a three-point international arbitrage, the trader sells currency ‘A’ and buys currency ‘B’. Then he/she sells currency ‘B’ and buys currency ‘C’. In the last leg of the arbitrage, he/she sells currency ‘C’ and buys currency ‘A’.
An international arbitrage is a risk-free trade but is very hard to spot. In the era of digital trading, sophisticated computers are used to take advantage of arbitrage opportunities. The price differential in international arbitrage may be low, but with adequate volume, substantial gains can be registered.