With foreign exchange investments, the strategy known as arbitrage lets traders lock in gains by simultaneously purchasing and selling an identical security, commodity, or currency, across two different markets. This move lets traders capitalize on the differing prices for the same said asset across the two disparate regions represented on either side of the trade.
- Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market, for a higher price.
- The temporary price difference of the same asset between the two markets lets traders lock in profits.
- Traders frequently attempt to exploit the arbitrage opportunity by buying a stock on a foreign exchange where the share price hasn't yet been adjusted for the fluctuating exchange rate.
- An arbitrage trade is considered to be a relatively low-risk exercise.
What Is Arbitrage?
Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share. In the stock market, traders exploit arbitrage opportunities by purchasing a stock on a foreign exchange where the equity's share price has not yet adjusted for the exchange rate, which is in a constant state of flux. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, positioning the trader to harvest gains from this differential. Although this may seem like a complicated transaction to the untrained eye, arbitrage trades are actually quite straightforward and are thus considered low-risk.
Example of Arbitrage
Consider the following arbitrage example: TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). On a given day, let's assume the stock trades for $63.50CAD on the TSX and for $47.00USD on the NYSE. Let's further assume the exchange rate of USD/CAD is $1.37, meaning that $1USD = $1.37CAD, where $47USD = $64.39CAD. Under this set of circumstances, a trader can purchase TD shares on the TSX for $63.50CAD and can simultaneously sell the same security on the NYSE for $47.00USD, which is the equivalent of $64.39CAD, ultimately yielding a profit of $0.89 per share ($64.39 - $63.50) for this transaction.
Beware of Transaction Costs
When contemplating arbitrage opportunities, it is essential to bake transaction costs into the mix, because if costs are prohibitively high, they may threaten to neutralize the gains from those trades. Case in point: In the aforementioned scenario, if the trading fee per share exceeded $0.89, the total arbitrage return would nullify those profits.
Price discrepancies across markets are generally minute in size, so arbitrage strategies are practical only for investors with substantial assets to invest in a single trade.
The Bottom Line
If all markets were perfectly efficient, and foreign exchange ceased to exist, there would no longer be any arbitrage opportunities. But markets are seldom perfect, which gives arbitrage traders a wealth of opportunities to capitalize on pricing discrepancies.