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What is arbitrage?

With foreign exchange rates constantly in flux, currency trading provides investment opportunities. One strategy that can yield a low-risk profit is arbitrage trading. Keep reading to find out what arbitrage is and how it works.

What is arbitrage in trading?

When a trader makes a purchase in one market and simultaneously sells it in another, this is referred to as arbitrage. Arbitrage can be applied to the trade of securities, commodities, or currencies across two markets.

The security’s purchased in one market at a lower price, and simultaneously sold in the secondary foreign exchange market at a higher price. According to the arbitrage pricing theory, because the share price hasn’t been adjusted yet in the secondary market to account for fluctuating exchange rates, this practice can offer instant profit. The share price is considered to be undervalued compared to its price on the secondary exchange.

How does arbitrage work?

It may seem complicated, but arbitrage pricing theory is straightforward and relatively low risk for traders. It takes advantage of financial market inefficiencies, working due to small discrepancies in the price of identical financial instruments. These discrepancies arise when a particular asset or currency is priced differently by financial institutions in different regions. When you buy the asset at a lower price from one financial institution and sell it instantly to another, you’ll gain any profit from these small discrepancies.

Arbitrage trading must be fast paced to be effective, giving the trader a chance to turn a profit before the fluctuations flip the opposite way. Risk is always inherent in any form of trading. If liquidity is low or the prices move faster than the trader, arbitrage may not always lead to gain. Any change in supply and demand can lead to sudden fluctuations in asset pricing. However, it’s these same sudden fluctuations that arbitrage traders use to their advantage, seeking out any tiny glitches or price differences. Automated trading systems are useful in this regard, relying on algorithms to spot these glitches as they happen.

Types of arbitrage

There are a few different types of arbitrage to be aware of:

  • Covered interest arbitrage: This strategy uses the difference in interest rates between two different countries. It uses a forward contract as a hedge to cover any risk inherent in changes to exchange rates.

  • Two-currency arbitrage: This strategy takes advantage of the different quotes between two separate currency pairs, rather than the differences between two currencies combined in the same pair.

  • Triangular arbitrage: When you involve three different currencies, this strategy is called a triangular arbitrage. With this type of trading situation, you can convert one currency into two others before converting it back into its original state, ideally at a profit.

  • Statistical arbitrage: For slightly higher-frequency trading, statistical arbitrage analyses the price movements of thousands of different markets and instruments. With the help of algorithms, investors can open long and short positions at the same time to benefit from inefficient pricing models.

Example of arbitrage trading

To better understand what is arbitrage in a real-life scenario, you can use the following example. In this case, we’ll look at two-currency arbitrage since that is the most straightforward option in forex trading.

Imagine that there are two different banks, which we’ll call Bank A and Bank B. Each bank has set different rates on the conversion between EUR and GBP. 

  • Bank A buys one euro at £0.9100 and sells it at £0.9200

  • Bank B buys one euro at £0.9300 and sells it at £0.9400

A trader could buy euros from bank A at a rate of £0.9200 each, selling them immediately to bank B who is buying euros at a rate of £0.9300 each. For every euro sold, the trader would make £0.0100. That means with £10,000 invested, the trader would make a £100 profit.

Arbitrage costs

Of course, there are transaction costs and other potential fees worked into any arbitrage trade. If the profit margin is too small, these transaction fees might overshadow any gains, making the trade a loss. It’s also important to remember that price discrepancies tend to be very small, so for arbitrage trading to be profitable you need to be able to work with substantial starting assets.

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