What is Forex Arbitrage?
Forex Arbitrage is a risk-free trading strategy in which the trader goes short and long simultaneously in different markets.
The aim of this type of trading is to take advantage of pricing inefficiencies between forex markets in order to tap any potential profits. Price discrepancies tend to be rare however, because markets tend to move towards balance, making arbitrage opportunities limited.
Nevertheless, skilled and experienced forex traders will be able to more easily identify these opportunities and to take advantage of them. There are several different types of forex arbitrage opportunities.
Types of Forex Arbitrage
Cross currency transactions – In this type of forex arbitrage, the currency pair does not include the US dollar. The differences in pricing between currency pairs or the cross rates of different currency pairs creates arbitrage opportunities.
Spot-future arbitrage occurs whenever a trader purchases currency in the spot market while at the same time sells the same currency in the futures market or vice versa. There must be a price discrepancy between both markets in order for profits to be possible.
Currency arbitrage relies on differences in price quotes instead of actual differences in exchange rates of currency pairs.
Covered interest rate arbitrage is another type of arbitrage in which traders aim to profit from higher yielding currencies based on differences in interest rates. The exchange rate risk is hedged with a forward currency contract that is implemented simultaneously.
In uncovered interest rate arbitrage, the domestic currency that may be yielding a lower rate of interest, is changed for a foreign currency with a higher interest rate.
Triangular arbitrage is a special type of arbitrage in which positions are taken in 3 currency pairs rather than in 2, in order to increase the opportunity for profits.
Identifying Forex Arbitrage Opportunitie
Since forex arbitrage opportunities exist only in short windows of time, forex arbitrage calculators are available to help traders to quickly spot pricing inefficiencies. These may be purchased from forex brokers or through other third parties. It is advisable for traders to test out these calculators through demo accounts before committing to a particular forex arbitrage calculator.
With the rise of electronic trading which facilitates speedier trades, the opportunities for forex arbitrage are getting fewer. Prices move towards equilibrium at a much quicker pace than previously, with some prices coming to equilibrium in as little as one or a few seconds. During periods of high market volatility, there may be price quote mistakes, delayed updating of price quotes in the system, as well as circumstances in which institutional investors cause errors due to their attempts to cover their clients.
Even though forex arbitrage is considered as risk free theoretically, in practice, there are certain risks involved. One of the risks involved in forex arbitrage is known as execution risk. This is the risk that prices will change before the trades are executed, or that prices will be requoted before transactions are completed. In such situations, it is possible to make a loss in forex arbitrage trading.