What is Forex Arbitrage
Forex arbitrage is the simultaneous purchase and sale of currency in two different markets. Arbitrage in itself is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in various forms. So, with forex arbitrage, foreign exchange traders acquire currency pairs to exploit any short-term pricing inefficiency between them. However, 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 profits by simultaneously purchasing the currency from the one seller, and selling it to the buyer. However, there is the hazard of execution risk if the price should change or re-quote, which could reduce the profit or generate a loss.
Electronic trading, which is high-frequency trading using algorithms and dedicated computer networks, 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, before reaching equilibrium. However, volatile markets and price quote errors or staleness can still provide arbitrage opportunities.
Other forex arbitrage includes:
- Currency arbitrage involves the exploitation of the differences in quotes rather than movements in the exchange rates of the currencies in the currency pair.
- A cross-currency transaction is one that consists of a pair of currencies traded in forex that does not include the U.S. dollar. Ordinary cross currency rates involve the Japanese yen. Arbitrage seeks to exploit pricing between the currency pairs, or the cross rates of different currency pairs.
- In covered interest rate arbitrages the practice of using favorable interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward currency contract.
- An uncovered interest rate arbitrage involves changing a domestic currency which carries a lower interest rate to a foreign currency that offers a higher rate of interest on deposits.
- 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 challenging 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 performance. 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. The cost of funds may limit traders at smaller banks or brokerages. Spreads, as well as trading and margin cost overhead, are additional risk factors.