Arbitrage has been in practice since ancient times. Arbitrage is a speculative strategy, where someone attempts to profit from price differences of the same instrument either in the same market or in different markets. It involves buying and selling an asset at two different prices in order to profit from the difference. For example you buy the instrument when you see it costs less in a market and then sell it in another market or in the same market where it costs slightly more.

Finding the right conditions and applying an arbitrage trading strategy is not easy because everyone is looking for a loophole in the market in order to make a profit. Therefore, by the time it comes to your attention, someone else may have already placed a trade and closed. So, arbitrage is mostly a strategy for market participants with the best and quickest information and technology systems.

However, did you know that traders can also make profits with very low risk through Forex arbitrage? If you don’t know what Forex arbitrage is, then you’re in the right place. In this article, we’ll cover everything you need to know about the Forex arbitrage strategy and give examples on how it works.

What is Forex Arbitrage?

Traders seeking to arbitrage Forex prices are in essence effectively aim to purchase a cheaper version of a currency, while simultaneously selling a more expensive version. Once they subtract their transaction costs, their profit is the remaining difference between the two prices. A Forex arbitrage system might operate in a number of different ways, but the essence is the same. Namely, arbitrageurs aim to exploit price anomalies. They might attempt to exploit price discrepancies between spot rates and currency futures.

A future is an agreement to trade an instrument at a certain date for a fixed price. Forex broker arbitrage might occur where two brokers are offering different quotes for the same currency pair. In the retail FX market, prices between brokers are normally uniform. Therefore, the feasibility of this strategy tends to be limited to the institutional market. This is also not the only type of arbitrage Forex trading opportunity to arise in the spot market.

Types of Arbitrage system

There are three main types of forex arbitrage:

Two-currency arbitrage

Two-currency arbitrage is the exploitation of the different quotes of two currency pairs instead of the differences in price between two currencies in the same pair. Let’s first look at an example of two-currency arbitrage. Most often, currency arbitrage involves trading the same two currencies with two different brokers in order to exploit any difference in price.

As an example of currency arbitrage, let’s suppose that two different banks – bank A and bank B – have set different rates on EUR/USD:

• Bank A is buying one euro at $1.6100 and selling at $1.6200
• Bank B is buying one euro at $1.6300 and selling at $1.6400

In this example, a trader could buy euros from bank A, which is selling at $1.6200, and then immediately sell those euros to bank B, which is buying for $1.6300. If the trader does this with an initial investment of $100,000, they could net a quick profit of $1000.

However, the trader would need to act fast after spotting this discrepancy in pricing because as soon as a few traders notice, the forces of supply and demand will cause the banks to adjust their pricings and the opportunity for arbitrage would be lost.

Covered interest arbitrage

Covered interest arbitrage is a trading strategy in which a trader can exploit the interest rate differential between two countries. They do this by using a forward contract to control their exposure to risk. The forward contract enables the trader to lock in an exchange rate in the future, while at the same time buying currency at the spot price in the present.

In a covered interest arbitrage strategy for EUR/USD a trader could do the following:

• Start with a certain amount of US dollars
• Recognise that the interest rate in the eurozone is more favourable than interest rates in the US
• Convert the dollars into euros at the spot price and invest in the eurozone. At the same time, organise a forward contract with a fixed exchange rate on EUR/USD to hedge against any shifts in the exchange rate over the investment period
• Realise the interest rate payments on euros
• Convert your euros back into US dollars at the exchange rate guaranteed by the forward contract.

To explain covered interest arbitrage in greater deal, here is a step by step example of how it works:

1. Start with $3,000,000

2. Identify that the euro currently has an interest rate of 4.8%, compared to the dollar interest rate of 3.4%

3. Convert $3,000,000 into euros. At an exchange rate of 1.2890 that would give you €2,327,385

4. To protect against exchange rate risk, take out a forward contract that locks in a 1.2845 exchange rate on EUR/USD for a year’s time

5. Invest €2,327,385 at 4.8% interest rate for a year to get €111,714 in profit from interest payments, giving you a total of €2,439,099

6. Change this back into dollars at the exchange rate guaranteed by your forward contract (1.2845) for $3,133,022. This is more than the $3,102,000 you would have had if you had invested in the US at 3.4% over the year instead.

1. Forex Triangular Arbitrage

Forex triangular arbitrage is a method that uses offsetting trades to profit from price discrepancies in the Forex market. To understand how to arbitrage FX pairs, we first need to understand the basics of currency pairs. Let’s run through some quick basics. When you trade a currency pair, you are in effect taking two positions: Buying the first-named currency, and selling the second-named currency.

A currency cross is an FX pair that does not include the US dollar. A theoretical or synthetic value for a cross is implied by the exchange rates of the currencies in question, versus the US dollar. For example, let’s suppose that the EUR/USD currency pair is trading at 1.1852, and the GBP/USD currency pair is trading at 1.3289. We can calculate an implied value for the EUR/GBP currency pair by dividing one by the other.

• Example: 1.1850/1.3287 = 0.8918

Why do we divide one by the other? Simply put, currency pairs can be treated as fractions with numerators and denominators.

Dividing by GBP/USD is the same as multiplying by the inverse. Therefore: EUR/USD x USD/GBP = EUR/GBP x USD/USD = EUR/GBP. If the actual traded value of the EUR/GBP currency pair diverges from the value implied by the major pairs, an arbitrage FX opportunity exists. As its name suggests, triangular FX arbitrage consists of three trades. Let’s say that EUR/GBP is actually trading at 0.8920.

It is higher than our implied value, and we want to sell it. We also need to place two trades in the two related majors, to create a synthetic EUR/GBP opposing position. This will offset our risk and thereby lock-in profit. Because the price discrepancy is small, we will need to deal in a substantial size to make it worthwhile.

Let’s work through the numbers to complete our example for this Forex arbitrage strategy. If we purchase 10 lots of EUR/USD – one lot is 100,000 units of the first-named currency. When we buy a currency pair, we are buying the first currency and selling the second. So we are buying 10 lots x 100,000 EUR = 1,000,000 EUR.

As we are dealing at a EUR/USD rate of 1.1850, we are selling 1,000,000 x 1.1850 = 1,185,000 USD. We simultaneously want to sell an equivalent amount of EUR in EUR/GBP. So we sell 10 lots of EUR/GBP, which is 1,000,000 EUR. As we are dealing at a EUR/GBP rate of 0.8920, we are buying 1,000,000 x 0.8920= 892,000 GBP.

Lastly, we also sell GBP/USD in order to complete the triangle. This leaves us with no overall exposure to any of the three currency pairs. To remove our exposure to GBP, we would sell the same amount that we bought in the EUR/GBP trade. Therefore, we sell 892,000/100,000 = 8.92 lots of GBP/USD. We are dealing at a GBP/USD rate of 1.3287 so we are buying 892,000 x 1.3287 = 1,185,200 USD. Consider the implication: if you were physically exchanging currencies at these rates and in these amounts, you would have ended up with 1,185,200 USD after initially exchanging 1,185,000 USD into EUR.

So your profit would be: 1,185,200 – 1,185,000 = 200 USD. As you can see, the profit is small, and relative to the large transaction size. Also note that we have not taken into account the bid/offer spreads, nor other transaction costs. Of course, with a retail FX broker you are not physically exchanging currencies either. You would have locked in a profit with the trades, but you would still have to unwind your positions. Keep in mind that daily SWAP adjustments would quickly erode the notional profit you have locked-in.

Conclusion

All trading systems are subject to the risk that profitability will erode with time. Arbitrage is a well-known technique that aims to exploit price differences of the same asset on different markets. Arbitrage opportunities can occur in all types of markets, even in your supermarket. While arbitrage is often considered risk-free, it’s important to calculate transaction costs and slippage into the equation since these costs can easily make an arbitrage opportunity worthless.

Arbitrage enables a trader to exploit market inefficiencies to generate a low-risk profit. In addition, since the differences in exchange rates on the Forex market are usually very small or don’t exist at all, position sizes need to be relatively large to make a notable profit from the arbitrage opportunity. The fierce competition in the FX market means you may discover pure arbitrage opportunities are limited.