What is currency arbitrage?
Currency arbitrage is a forex strategy in which a currency trader takes advantage of the different spreads offered by brokers for a particular currency pair by making trades. Different spreads for a currency pair imply disparities between the bid and ask prices. Currency arbitrage involves buying and selling currency pairs from different brokers to take advantage of mispriced rates.
Key points to remember
- Currency arbitrage is the exploitation of differences in quotes offered by brokers.
- Currency arbitrage can be practiced using different strategies, such as two-currency arbitrage and three-currency arbitrage.
Understanding currency arbitrage
Currency arbitrage involves the exploitation of differences in quotes rather than movements in the exchange rates of the currencies of the currency pair. Forex traders generally practice two-currency arbitrage, in which the differences between the spreads of two currencies are exploited. Traders can also practice three currency arbitrage, also known as triangular arbitrage, which is a more complex strategy. Due to the use of computers and high speed trading systems, large traders often detect differences in quotes of currency pairs and quickly close the gap.
The most important risk that forex traders face when trading currencies is execution risk. This risk refers to the possibility that the desired currency quote will be lost due to the rapidly changing nature of forex markets.
Example of monetary arbitrage
For example, two different banks (Bank A and Bank B) offer quotes for the US / EUR currency pair. Bank A sets the rate at $ 3/2 per euro and Bank B sets its rate at $ 4/3 per euro. In currency arbitrage, the trader would take one euro, convert it to dollars with bank A and then back to euro with bank B. The result is that the trader who started with one euro now has 9/8 euros. The trader made a profit of 1/8 euro if the trading costs are not taken into account.
By definition, currency arbitrage requires the buying and selling of two or more currencies to occur instantly, as an arbitrage is supposed to be risk free. With the advent of online portals and algorithmic trading, arbitrage has become much less common. With high price discovery, the ability to benefit from arbitrage decreases.