In theory, a given currency should carry the same price in different locations/markets. However, market inefficiencies resulting from communication difficulties may result in different prices emerging in different locations at the same time. Arbitrage, takes advantage of these inefficiencies to the benefit of a trader.
The process of buying goods/currency in one market and selling the same in another market is known as arbitrage. Arbitrage profit is risk less profit.
Arbitrage trading exploits price differences across markets by buying low and selling high instantly, helping maintain market efficiency and fair pricing.
Essentially the trader relies on a particular currency being priced differently in two different places at the same time.
There are two types of arbitrages in forex markets:
(i) Exchange rate arbitrage: Earning profit from differences in exchange rates in different markets.
(ii) Interest rate arbitrage: Earning profit from differences in interest rates between countries.
Two-point arbitrage: Two-point arbitrage concerns two currencies in two geographically separated markets.
Let’s take this example
SR ￡1 = $1.65 in London and
SR ￡1 = $1.70 in New York
Suppose $ 1000000, is there any arbitrage profit possible?
Sterling is undervalued in London and overvalued in New York. Provided that capital was free to
flow between the two countries, arbitrageurs would attempt to exploit, and hence profit from, the
differential by selling dollars for pounds in London and reselling the pounds in New York.
Arbitrage Profit is possible as follows:
Buying Rate of ￡ 1 in London = $1.65
Selling Rate of ￡ 1 in NY = $1.70
Since selling rate is more than buying rate, hence arbitrage profit is possible
Arbitrage Profit per ￡ = Selling Rate – Buying Rate = $1.70 – $1.65 = $0.05
The arbitrageur would sell $1 million in London, hence
￡ receivable by selling $ 1000000 in London = $1000000/1.65 = ￡606060,60.
$ receivable by selling ￡606060.60in NY = ￡606060.60*1.70 = $1030303.02
Arbitrage Profit = $30303.02
Three-point (triangular) arbitrage: Triangular arbitrage is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market.
Let’s take this example
In NY USD 1 = CHF 1.6639 – 1.6646 – (i) [CHF/USD]
In London USD 1 = Euro 0.9682 – 0.9686 – (ii) [Euro/USD]
In Australia Euro 1 = CHF 1.6410 – 1.6423 – (iii) [CHF/Euro]
Assume we have with $ 1 Millon, is there any arbitrage profit possible?
Alternative 1
a) Sell $ 1,000,000 in London, Euro receivable = $ 1000000*0.9682 = Euro 968200
(b) Sell Euro 968200 in Australia, CHF receivable = Euro 968200*1.6410 = CHF1588816
(c) Sell CHF 1588816 in NY, $ receivable = CHF 1588816/1.6646 = $ 954473
Loss due to above process = $1000000 – $ 954473 = $ 45527
Alternative 2
(a) Sell $ 1,000,000 in NY, CHF receivable = $ 1000000*1.6639 = CHF 1663900
(b) Sell CHF 1663900 in Australia, Euro receivable = CHF 1663900/1.6423 = Euro 1013152
(c) Sell Euro 1013152 in London, $ receivable = Euro 1013152/0.9686 = $ 1045996
Gain due to above process = $1045996 – $ 1000000 = $ 45996
Arbitrage profit under alternative 2 = $ 45996 In essence, arbitrage is not merely a profit-making activity; by exploiting price differences across markets, arbitrageurs eliminate mispricing, thereby restoring uniform prices and maintaining stability in exchange rates and interest rates.