What Is Currency Arbitrage?
Currency arbitrage, also known as forex arbitrage or arbitrage currency trading, is a forex trading strategy where the currency trader takes advantage of the range of spreads offered by brokers a particular pair of currencies. The range of spreads for a pair of currencies implies disparities between the bid price and ask price. Hence, currency arbitrage involves buying as well as selling of currency pairs from a variety of brokers so that one can take advantage of the mispriced rates.
In general, instead of observing the movements in exchange rates of the currencies in the pair of currencies, currency arbitrage involves taking advantage of the differences in quotes. Forex traders tend to practice what is referred to as ‘two-point arbitrage,’ in which the disparities in the spread of currencies are exploited. Some forex traders also practice three currency arbitrage which is referred to as triangular arbitrage, which is more complex. They do this with the aid of computers that employ high-speed trading systems, so large traders can often catch these differences in the pair quotes and close the gap soon.
Example of Currency Arbitrage
In Indian stock markets, the most popular arbitrage available is referred to as a cash-futures arbitrage. Here is an example of it. Suppose stock A trades at ₹328 and A’s Futures for next month are to be traded at ₹330. The trader will first buy the stock and then sell the futures contract. Keep in mind that lot size is associated with derivatives trading. If the lot size of A is 1000 shares, the number of shares traded should be equal to that in the lots.
At the time of expiry, you can predict that the price of the futures and that in the cash market will be the same. At expiry, you can expect the price of the future and the cash market to be the same since any difference you might have earned would be profit. This is referred to as cash and carry/cash-futures arbitrage. However, there are different ways in which one can carry out currency arbitrage.
Choosing a Currency Arbitrage Strategy
There are many types of arbitrage strategies: futures arbitrage, triangular arbitrage, statistical arbitrage, and two-point arbitrage, to name a few. Choosing the ideal forex arbitrage strategy to use given your situation and preference for risk will also depend on what markets you have access to. For instance, an experienced cross currency trader will have a decent grip on triangular arbitrage. Alternatively, a trader with the accessibility to a currency futures market has the option to carry out futures forex arbitrage provided they can trade in large enough volumes with sufficiently inexpensive transaction costs.
In both cases, the traders would have the expertise to identify their individual arbitrage opportunities virtually in real-time. In case one does not have access to a futures market, and is a retail investor, they can employ statistical arbitrage which involves mathematically determining an arbitrage opportunity. If you have access to more markets geographically, two-point arbitrage could be an option for you. Finally, retail investors or beginners can also make use of analysis tools to determine when a potential arbitrage opportunity has arisen.
Risk Associated with Arbitrage Currency Trading
It’s incorrect to think that arbitrage is easy money for a forex trader, as this is far from the truth. While arbitrage currency trading can help bring in a lot of profit, it has also been shown to cause some of the biggest financial collapses. Generally, this typically occurs when the underlying parameters that make or break the trade change. So, this risk-free profit that the investor was vying for becomes a locked-in loss.
The biggest risk that a forex arbitrage trader has to deal with while arbitraging their currencies is called an execution risk. Execution risk refers to the possibility that one’s desired quote for the currency they are trading could become unavailable due to the fast paced nature of a forex market. Achieving this risk free profit result typically involves opting for a certain degree of risk that is taken during the execution of the trade, as mentioned above.
Often, the risk of execution tends to exceed the small gains that arbitrageurs can commonly take in. Spreads between currency pairs are assessed and the opposing positions are taken especially when the prices get substantially out of hand when compared to the historical norms set in place. However, this window of opportunity is so slim that investors risk losing this gap.