WHAT IS 'Forex Arbitrage'

Forex arbitrage is the simultaneous purchase and sale of currency in two different markets. Foreign exchange traders acquire currency pairs to exploit any short-term pricing inefficiency between them. But prices tend to move toward equilibrium across markets, so it may be difficult to find such price discrepancies.

BREAKING DOWN 'Forex Arbitrage'

Forex arbitrage can occur, for example, when a trader at one bank offers to sell a currency at a lower price than a trader at another bank is offering to buy it. A forex arbitrage trade profit by simultaneously buying currency from the seller and selling it to the buyer. However, there is execution risk if the price changes or is requoted, which could reduce the profit or generate a loss.

Electronic trading—high-frequency trading using algorithms, as well as dedicated computer networks to execute trades—has shortened the timeframe for forex arbitrage trades. Previously, price discrepancies would last several seconds. Now they may remain for only a second or less, then reach equilibrium. However, volatile markets and price quote errors or staleness can provide arbitrage opportunities.

Cross-currency, interest rate and spot-future trades are other methods of forex arbitrage. Cross-currency arbitrage seeks to exploit pricing between three currency pairs or the cross rates of different currency pairs. With interest rate arbitrage, a trader would sell currency from a country with low interest rates and buy and hold currency from a country with higher rates. When the trade is closed, the buyer would receive the net of the interest paid on the two currencies. Spot-future arbitrage involves taking positions in the same currency in the spot and futures markets. For example, a trader would buy currency on the spot market and sell the same currency in the futures market if there is a beneficial pricing discrepancy.

‘Forex Arbitrage’ Challenges

Some circumstances can hinder or prevent arbitrage. A discount or premium may result from currency market liquidity differences, which is not a price anomaly or arbitrage opportunity, making it more difficult to execute trades to close a position. Arbitrage demands rapid execution, so a slow trading platform or trade entry delays can limit opportunity. Time sensitivity and complex trading calculations require real-time management solutions to control operations and execution. This need has resulted in the use of automated trading software to scan the markets for price differences to execute forex arbitrage.

Forex arbitrage often requires lending or borrowing at near to risk-free rates, which generally are available only at large financial institutions. Traders at smaller banks or brokerages may be limited by the cost of funds. Spreads as well as trading and margin cost overhead are additional risk factors.

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