Currency Arbitrage

Currency Arbitrage

A currency arbitrage is a forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades. A currency arbitrage is a forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades. Currency arbitrage can be practiced using different strategies, such as two-currency arbitrage and three-currency arbitrages. In currency arbitrage, the trader would take one euro, convert that into dollars with Bank A and then back into euros with Bank B. By definition, currency arbitrage requires the buying and selling of the two or more currencies to happen instantaneously, because an arbitrage is supposed to be risk free.

Currency arbitrage is the exploitation of differences in quotes offered by brokers.

What Is Currency Arbitrage?

A currency arbitrage is a forex strategy in which a currency trader takes advantage of 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 the mispriced rates. 

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 arbitrages.

Understanding Currency Arbitrage

Currency arbitrage involves the exploitation of the differences in quotes rather than movements in the exchange rates of the currencies in the currency pair. Forex traders typically 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 catch differences in currency pair quotes and close the gap quickly.

The most important risk that forex traders must deal with while arbitraging currencies is execution risk. This risk refers to the possibility that the desired currency quote may be lost due to the fast-moving nature of forex markets.

Example of Currency 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 dollars per euro, and Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the trader would take one euro, convert that into dollars with Bank A and then back into euros with Bank B. The result is that the trader who started with one euro now has 9/8 euros. The trader has made a 1/8 euro profit if trading fees are not taken into account.

By definition, currency arbitrage requires the buying and selling of the two or more currencies to happen instantaneously, because an arbitrage is supposed to be risk free. With the advent of online portals and algorithmic trading, arbitrage has become much less common. With price discovery high, the ability to benefit from arbitrage falls.

Related terms:

Arbitrage

Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from a difference in its price. read more

Currency Basket

A currency basket is comprised of a mix of several currencies with different weightings. read more

Forex Arbitrage

Forex arbitrage is the simultaneous purchase and sale of currency in two different markets to exploit short-term pricing inefficiency.  read more

Funding Currency

A funding currency is exchanged in a currency carry trade. read more

Index Arbitrage

Index arbitrage is a trading strategy that attempts to profit from the differences between actual and theoretical prices of a stock market index. read more

Triangular Arbitrage

Triangular arbitrage involves the exchange of a currency for a second, then a third and then back to the original currency in a short amount of time. read more