In thee context of Foreign Exchange (FX), arbitrage refers to the practice of exploiting price differences in the exchange rates of the same currency pair across different markets or platforms to make a profit. The goal of arbitrage is to buy a currency at a lower price in one market and simultaneously sell it at a higher price in another, without any risk, because the transactions occur almost simultaneously.
How it Works:
- Triangular Arbitrage: This involves using three different currencies to exploit discrepancies in the exchange rates between them. For example, you might start with USD, convert it into EUR, then convert the EUR into GBP, and finally convert the GBP back into USD. If the exchange rates in the market create a situation where you end up with more USD than you started, you’ve made a profit.
- Simple Arbitrage: Involves buying a currency at a lower rate in one market and selling it at a higher rate in another market. For example, if the EUR/USD exchange rate is 1.1000 in New York and 1.1020 in London, you could buy euros in New York and sell them in London to make a profit.
Example:
1. **Exchange Rate Discrepancy**: Assume that the exchange rate for USD to EUR is 1 USD = 0.85 EUR in Market A and 1 USD = 0.86 EUR in Market B.
2. **Arbitrage Opportunity**: A trader can buy USD in Market A (where 1 USD = 0.85 EUR) and then sell it in Market B (where 1 USD = 0.86 EUR). By doing this, the trader can make a profit on each trade without any risk.
3. **Profit**: For every 1,000 USD traded:
- Buy in Market A: 1,000 USD → 850 EUR.
- Sell in Market B: 850 EUR → 988.37 USD.
- Profit: 988.37 USD – 1,000 USD = 1.18 USD.
- Profit: 988.37 USD – 1,000 USD = 1.18 USD.
Key Points:
- **No Risk**: Arbitrage relies on price discrepancies between markets, so the strategy involves no risk if executed properly.
- **Short-Lived**: These opportunities are typically short-lived as the market tends to correct the price difference quickly. Automated trading systems and algorithms are often used to identify and exploit these opportunities.
- **Market Efficiency**: Arbitrage helps make markets more efficient by eliminating price discrepancies.
Arbitrage plays an important role in ensuring that prices across different markets converge, maintaining fairness and liquidity in the FX market.