Forex Arbitrage: Meaning, Types, Challenges

What Is Forex Arbitrage?

Forex arbitrage is the strategy of exploiting price disparity in the forex markets. It may be effected in various ways but however it is carried out, the arbitrage seeks to buy currency prices and sell currency prices that are currently divergent but extremely likely to rapidly converge. The expectation is that as prices move back towards a mean, the arbitrage becomes more profitable and can be closed, sometimes even in milliseconds.

How Forex Arbitrage Works

Because the Forex markets are decentralized, even in this era of automated algorithmic trading, there can exist moments where a currency traded in one place is somehow being quoted differently from the same currency in another trading location. An arbitrageur able to spot the discrepancy can buy the lower of the two prices and sell the higher of the two prices and likely lock in a profit on the divergence.

For example, suppose that the EUR/JPY forex pair was quoted at 122.500 by a bank in London, but was quoted at 122.540 by a bank in Tokyo. A trader with access to both quotes would be able to buy the London price and sell the Tokyo price. When the prices had later converged at say, 122.550, the trader would close both trades.

The Tokyo position would lose 1 pip, while the London position would gain 5, so the trader would have gained 4 pips less transaction costs.

Making Small Profits Worthwhile

Such an example may appear to imply that a profit so small would hardly be worth the effort, but many arbitrage opportunities in the forex market are exactly this small, or even more so. Because such small discrepancies could be discoverable across many markets many times a day, it was worthwhile for specialized firms to spend the time and money to build the necessary systems to capture these inefficiencies. This is a big part of the reason the forex markets are so heavily computerized and automated nowadays.

Automated algorithmic trading has shortened the timeframe for forex arbitrage trades. Price discrepancies that could last several seconds or even minutes now may remain for only a sub-second before reaching equilibrium. In this way, arbitrage strategies have made the forex markets more efficient than ever. However, volatile markets and price quote errors or staleness can and do still provide arbitrage opportunities.

Other Types of Forex Arbitrage

• 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 that 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.

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