When it comes to trading in currencies, there are a host of pricing discrepancies and mispricings that can be successfully exploited to earn profits. Such minor price differences are usually in the exchange rates of various currencies. This is primarily why most forex traders and investors tend to use arbitrage strategies to capture these mispricings. One of the most popular among the various arbitrary trading strategies is locational arbitrage. If you’re wondering what it is, keep reading to find out.
What is the locational arbitrage strategy?
To understand the concept of location arbitrage, you first need to know what arbitrage is.
Technically, arbitrage is a trading strategy that involves you simultaneously purchasing and selling an asset such as stocks, commodities, or currencies to capture minor price differences. You could either purchase and sell an asset in the same market or in different markets. While arbitrage trading strategies only offer a small amount of returns, they’re widely considered to be of low-risk. Certain arbitrages carry virtually zero risk as well.
Now that you know what arbitrage is, let’s get back to trying to understand locational arbitrage strategy.
Locational arbitrage can be defined as the act where an investor tries to exploit the minor exchange rate differences for a given currency pair between multiple banks for generating a profit. These differences between exchange rates are usually very thin and are generally valid only for a brief period of time. And so, to accurately be able to capture the price difference, an investor has to act swiftly. Otherwise, he might either miss the opportunity or his position would end up in a loss.
Why does the location arbitrage even exist?
One of the primary reasons for the existence of exchange rate mispricings is the fact that the entire currency market is not centralized. Unlike the stock markets that are heavily regulated and centralized through exchanges, the currency markets are completely unregulated over-the-counter markets. And since all the transactions occur electronically over the counter without any regulating entity or a central marketplace, the exchange rates might differ slightly from one bank to the other.
Locational arbitrage – an example
If the concept is still not very clear to you, here’s an example that can help you better understand it.
Assume that you’re a trader who wishes to trade the USD GBP currency pair. Here the base currency (the currency you sell) is the USD and the quote currency (the currency you purchase) is the GBP. So, if the exchange rate of the USD GBP currency pair is currently at 1.45, then you’re required to pay 1.45 USD to purchase 1 GBP.
Moving on, you approach a bank named ABC who quotes a bid ask spread of 1.43/1.45 for the USD GBP currency pair. Here, the bid value refers to the amount that the bank is willing to pay to purchase 1 GBP from you. And the ask value refers to the amount that you’re required to pay to purchase 1 GBP from the bank.
Simultaneously, you approach another bank named XYZ who quotes a bid ask spread of 1.47/1.49 for the same USD GBP currency pair. See how there’s a minor difference in the bid ask spreads between two different banks for the same currency pair? Here’s where you can successfully employ a location arbitrage.
To employ the locational arbitrage strategy, all you need to do is buy the GBP from bank ABC for 1.45 USD and immediately sell the GBP to bank XYZ for 1.47 USD. This way, you can make a profit of 0.02 USD for this trade. One of the advantages of this trade is that it is virtually risk-free.
As you can clearly see in the above example, locational arbitrage is one of the easiest trading strategies to execute. The hard part, however, is finding the price discrepancy in the exchange rates between different banks. It requires quite a bit of dedication and determination. That said, here’s something that you should note. Since the profit margins are very thin with location arbitrage, the strategy requires a significant amount of investment capital to earn high returns.