Currency Arbitrage

What Is Currency Arbitrage?

A currency arbitrage is a forex strategy in which a currency trader exploits various spreads offered by brokers for a specific currency pair by making trades. Various spreads for a currency pair infer inconsistencies between the bid and ask prices. Currency arbitrage includes buying and selling currency pairs from various brokers to exploit the mispriced rates.

Understanding Currency Arbitrage

Currency arbitrage includes the abuse of the differences in quotes as opposed to developments in the exchange rates of the currencies in the currency pair. Forex traders ordinarily practice two-currency arbitrage, in which the differences between the spreads of two currencies are taken advantage of. Traders can likewise practice three-currency arbitrage, otherwise called triangular arbitrage, which is a more complex strategy. Due to the utilization of PCs and high-speed trading systems, large traders frequently get differences in currency pair quotes and close the gap rapidly.

The main risk that forex traders must deal with while arbitraging currencies is execution risk. This risk alludes to the possibility that the ideal currency quote might be lost due to the fast-moving nature of forex markets.

Illustration of Currency Arbitrage

For instance, two distinct banks (Bank An and Bank B) offer quotes for the US/EUR currency pair. Bank A sets the rate at 3/2 dollars for every euro, and Bank B sets its rate at 4/3 dollars for each euro. In currency arbitrage, the trader would take one euro, convert that into dollars with Bank An and afterward back into euros with Bank B. The outcome is that the trader who began with one euro currently has 9/8 euros. The trader has made a 1/8 euro profit on the off chance that trading fees are not considered.

By definition, currency arbitrage requires the buying and selling of the at least two currencies to happen immediately, on the grounds that an arbitrage should be risk free. With the appearance of online entrances and algorithmic trading, arbitrage has become substantially less common. With price discovery high, the ability to benefit from arbitrage falls.

Highlights

• Currency arbitrage is the abuse of differences in quotes offered by brokers.
• Currency arbitrage can be practiced utilizing various strategies, for example, two-currency arbitrage and three-currency arbitrages.