Forex Arbitrage Defined
Agreeing to the perception ratified by certain economists in the 1990s, forex arbitrage is the instantaneous sale and purchase of equivalent or essentially same, security for gainfully different prices int two different marketplaces.
Arbitrageur is someone who practices it. He buys assets at cheaper prices and at the same time sells at more high-priced simultaneously, to revenue without net cash flow.
Due to the normal tendency for the prices to move to a level of equilibrium across marketplaces continuously, traders find it hard to detect discrepancies on price across the markets that let them buy assets at low rates.
The Negative Spread
While it is true that efficient markets theory works, practice traders discovered that marketplaces did not demonstrate themselves to be 100% competent all the time because of its asymmetric information amid sellers and buyers.
An example of market incompetence is when the ask price of a seller is cheaper than the bid of another buyer, which is also known as “negative spread”. This may occur when a bank marks a specific currency price while another bank has different price reference.
When this happens, an arbitrageur can profit by making a purchase from the seller, and a sale to the buyer, simultaneously. Basically, the trader begins on the profit’s situation, rather than waiting for a favorable progress of market movements.
Though risk-free Forex Trading sounds great in theory, again, traders should be mindful that losses can still occur.
Fast- Moving Market
Several opportunities for the alleged risk-free arbitrage have lessened with the increase of e-trading platforms. Traders today must at least be more alert and intelligent to execute trades. Yet, market researchers discovered that negative spread circumstances still surface in specific situations. These happen more often in market volatility periods. They may also happen due to errors on price quotes, failure to keep the old quotes in the trading system up -to-date or when participants from the institutional market seek to protect the outstanding positions of their clients.
It is a strategy on negative spread which may bid chances for profits. Triangular arbitrage comprises the trade of different currencies (three or more), hence increasing the possibility that profit opportunities will surface with market inefficiencies. Here, the traders will look for conditions where a particular currency is overpriced comparative to a current, but underpriced comparative to the other.
Interest Rate Arbitrage
It is another form, that is usual in trading currency, which is also called carry trade. It’s when investors sell currency from a certain country with cheap interest rates and purchase and store currency from a country that pays higher interests. The time that the investors reverse the procedure, they will have the take-home difference in interest compensated on the two currencies. Since this process has been carried out over time, the trader may be subjected to risks of differences in the interest rates or currency levels.
This is another form of arbitrage which is also known as cash and carry. This involves taking the same asset’s positions in both spot and future marketplace. Using this technique, a trader buys a core asset and sells the same in the future market while it is purchased. Same technique can be carried out in another direction, and that is called reverse cash and carry. Here, the trader sells the core asset and buys the same in the future market.
The practice of arbitrage can possibly be a helpful strategy in Forex Trading, to make sensible profits though may face a high risk of loss.
Irrespective of which market they choose to operate in, arbitrageurs must remain alert in the levels of price and be on guard as to when or when these occasions may arise.