Understanding Forex Arbitrage

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Forex Arbitrage

The Forex market opens its door for an endless supply of opportunities. It’s size, and aspects involved within its functionality has helped individuals come out with different kinds of strategies. With the end goal of earning profits and considerable returns, these strategies are tested. If they tend to provide an individual with positive results, then everything will head in the right direction. Otherwise, the strategy will not be considered, and traders will begin to ignore the same. On that front, there is a particular strategy that has been tried and tested. People who have utilised the same have come out with excellent results. Since we hate to keep you guessing, you need to know that we are talking about the Arbitrage or the Forex Arbitrage Trading strategy. So if you wish to gain more details about the same, then go ahead to learn more.

Forex market

What is it?

Forex Arbitrage is a unique strategy that gains momentum by exploiting the price disparity. It tends to act upon various opportunities that are presented by pricing inefficiencies that exist in the short window. For this purpose, it buys and sells different currency pairs with the primary purpose being to utilise an apparent inefficiency to a large extent. So to gain a deeper perspective about the same, let’s look into an example.

Forex Arbitrage

Imagine that the currency rates for EUR/USD, GBP/USD and EUR/GBP are 1.1837, 1.6388 and 0.7231. In such a scenario, a trader can purchase a mini-lot of EUR for $11,837. Soon after that, the trader can proceed to sell the same at 10,000 Euros for 7,231 British Pounds. In order to earn a profit, the 7,231 GBP can be sold for $11,850 that lands a profit of $13 per trade. This move also avoids open exposures since long positions tend to cancel short positions in each currency. The same trade can also be functioned by using normal lots of 100,000 that would, in turn, bring out a profit of about $130.

From the above example, it is quite clear how the system tries to utilise inefficiencies in order to correct a particular problem. But in such cases, traders also need to act quickly since these opportunities do not stick around for a long time. The short term nature of the Arbitrage needs to be understood by all means.

Points to be Noted

  1. Efficient – the arbitrage trading strategy not only helps you gain a balance over your investments, but it also helps the markets to be efficient.
  2. Circumstances – the process of Arbitrage will not be possible without the involvement of unusual circumstances.
  3. Temporary – the situations that promote you to perform this strategy are usually temporary and will not head for the long term.
  4. Fewer-Risks – since the process tries to make a profit with no open currency exposure, it tends to include fewer risks.

What Are the other Forms of Forex Arbitrage?

Thanks to the dynamic nature of Arbitrage, you can be assured of witnessing different forms. So to gain more clarity, let’s take a look into a few of these types.

Currency Arbitrage

  1. Currency Arbitrage – the aspect of currency arbitrage works with a different style of functionality. Instead of going for the movements of exchange rates, it looks into the differences in quotes of currency pairs.
  2. Covered-Interest Rate Arbitrage – this is another method that tends to utilise favourable interest rate differentials for the purpose of investing in high-yielding currencies and then hedges the exchange risk with the help of a forward contract.
  3. Triangular Arbitrage – a typical triangular arbitrage or cross-currency transaction is one that does not include the U.S dollar when it comes to pairs of currencies. It usually involves Yen and other forms of ordinary currency pairs.
  4. Spot-Future Arbitrage – this particular form of Arbitrage is something that has not been used by a lot of investors. Although they tend to quote their preferred reasons for the same, we firmly believe that it works through. The process is simple, and it involves taking positions in the same currency in a spot and future markets. But for this to click, one has to wait for pricing discrepancy. Since our markets tend to face different kinds of elements, it will arrive sooner or later. So by all means, an investor has to buy currency on the spot market and then wait to sell the same in the future market.
  5. Uncovered Interest Rate Arbitrage – this is a pure arbitrage that involves the process of changing a domestic currency, carrying a lower interest rate to a foreign currency that offers a higher interest rate.

What are its Challenges?

Since most of these strategies take place within the Forex market, it is quite obvious that it comes across specific challenges. On that front, it is now time to look at some of the many challenges that it faces.

Unforeseen Circumstances

  1. Unforeseen Circumstances – although Arbitrage thrives on unforeseen circumstances, certain situations manage to be problematic towards the process. A discount or premium is one such aspect that can hinder the strategy. When such discounts and deals come into the picture, they tend to bring about market liquidity differences. This is not a price anomaly, nor is it an arbitrage opportunity.
  2. Slow Trading- as we all know; Arbitrage requires a rapid platform or entry in order to make matters meet. Slow trading platforms or delays can limit the entire process and put it on hold. This tends to kill the rapid action that it requires and will permanently ruin everything for the worst.
  3. Limitations for Small Traders – the aspect of lending and borrowing for Arbitrage takes place at risk-free rates. Such kinds of rates are usually available only at large financial institutions and corporations. Thus the process leaves out smaller banks or traders who simply cannot afford these enormous costs. The margin cost overhead and spreads are additional factors that reduce the possibility for small traders to cast a spell with Arbitrage.

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