The Basics Of Forex Arbitrage

What Is Forex Arbitrage?

Forex arbitrage is defined as “the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices,” according to the concept formalised by economists Sharpe and Alexander in the 1990s.1)Retrieved 31 May 2016 https://research.stlouisfed.org/publications/review/02/11/EmmonsSchmid.pdf

Someone who practices arbitrage is known as an “arbitrageur.” Simply put, an arbitrageur buys cheaper assets and sells more expensive assets simultaneously to take a profit with no net cash flow. In theory, the practice of arbitrage should require no capital and involve no risk, although in practice attempts at arbitrage generally involve both. 2)Retrieved 31 May 2016 https://research.stlouisfed.org/publications/review/02/11/EmmonsSchmid.pdf

“Risk-Free,” Or Locational Arbitrage

According to economic theory, trading on financial markets is bound by the Efficient Markets Hypothesis, a concept developed by economist Eugene Fama and others from the 1960s onward. It suggests that markets (or more importantly all the active investors and participants in them) will process all available information about asset values and prices efficiently and quickly in such a way that there will be little, if any, room for price discrepancies across markets, and that prices will move quickly toward equilibrium levels.

Because of this natural tendency for prices to move toward equilibrium levels across markets at all times, traders may find it difficult to identify price discrepancies across markets that allow them to buy assets at “bargain rates.” Or, in the words of renowned economist Milton Friedman, there’s no such thing as a “free lunch.”3)Retrieved 31 May 2016 http://www.nber.org/papers/w18541.pdf

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The Negative Spread: A Free Lunch?

While the efficient markets theory indeed works, in practice traders have found that markets have not shown themselves to be 100% efficient at all times due to asymmetric information between buyers and sellers.

One such occasion of market inefficiency is when one seller’s ask price is lower than another buyer’s bid price, also known as a “negative spread.” For instance, this may happen when one bank quotes a particular price for a currency while another bank is referencing a different price. When a situation like this arises, an arbitrageur can make a quick profit by simultaneously executing a purchase from the seller and a sale to the buyer. In essence, the trader begins the trade in a situation of profit, rather than having to wait for a favourable evolution of market trends..

However, while risk-free trading may sound like a great deal in theory, once again, in practice, traders should be aware that losses can occur. The most common risk identified by traders in arbitrage trading is “execution risk.” This is the risk that price slippage or requotes can occur, making the trade less profitable or turning it into a loss. 4)Retrieved 31 May 2016 http://www.nber.org/papers/w18541.pdf

A Fast-Moving Market

With the rise of electronic trading platforms since the 1970s and the more recent growth of “high-frequency trading” using algorithms and dedicated computer networks to execute trades, some opportunities for so-called “risk-free” arbitrage have diminished. At the least, traders now must be much more agile and quick on the trigger finger to execute such trades. Whereas several years ago arbitrage trade opportunities may have lingered for several seconds, traders now report they may last for only a second or so before prices converge toward equilibrium levels.5)Retrieved 31 May 2016 https://www.capgemini.com/resource-file-access/resource/pdf/High_Frequency_Trading__Evolution_and_the_Future.pdf

However, market researchers have found that negative spread situations still do arise in particular circumstances. These tend to occur more often in periods of market volatility. They can also arise because of price quote errors, failure to update old quotes (stale quotes) in the trading system or situations where institutional market participants are seeking to cover their clients’ outstanding positions.6)Retrieved 31 May 2016 https://www.capgemini.com/resource-file-access/resource/pdf/High_Frequency_Trading__Evolution_and_the_Future.pdf

Triangular Arbitrage

A variation on the negative spread strategy that may offer chances for gains is triangular arbitrage. Triangular arbitrage involves the trade of three (or more) different currencies, thus increasing the likelihood that market inefficiencies will present opportunities for profits. In this strategy, traders will look for situations where a specific currency is overvalued relative to one currency but undervalued relative to the other.

An example of triangular arbitrage would be to trade in three currency pairs, such as EUR/USD, USD/JPY and EUR/JPY. If in this case the euro is undervalued in relation to the yen, and overvalued in relation to the dollar, the trader can simultaneously use dollars to buy yen and use yen to buy euros, to subsequently convert the euros back into dollars at a profit.7)Retrieved 31 May 2016 http://www.sfu.ca/~rgencay/jarticles/TriangularFX.pdf

Interest Rate Arbitrage

Another form of arbitrage that is common in currency trading is interest rate arbitrage, also known as “carry trade.” This is when an investor sells currency from a country with low interest rates and buys and holds a currency from a country paying higher interest rates. When the investor reverses the operation at a later time, they will receive the net difference in interest paid on the two currencies. Because this operation is carried out over a period of time, the trader also may be subject to risks of variations in the levels of currencies or in interest rates.

Spot-Future Arbitrage: Cash And Carry

An additional form of arbitrage, known popularly as “cash and carry,” involves taking positions in the same asset in both the spot and futures markets. With this technique, the trader buys an underlying asset and sells, or “shorts,” the same asset in the futures market while the asset is purchased.

A similar strategy can also be taken in the other direction, and it’s known as “reverse cash and carry.” In this operation, the trader sells the underlying asset and buys, or “goes long,” on the same asset in the futures market.8)Retrieved 31 May 2016 https://www.cfainstitute.org/learning/foundation/research/Documents/rf_clarke_summary_2013Nov11.PDF

Summary

The use of arbitrage can potentially be a valuable strategy for traders to make timely profits although there is also a high level of risk of loss. Advances in trading technology and high-frequency trading in some cases have made true “risk-free” arbitrage opportunities less common for small-scale investors. But they have also widened access to diverse markets where asymmetric information and market inefficiencies may still present arbitrage opportunities.

Regardless of which market an arbitrageur chooses to operate in, what’s most important is that they remain attentive to price levels and be on the lookout for when and where these opportunities may arise. Trading on margin carries a high level of risk and losses can exceed deposited funds.

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