What is Arbitrage trading?
At its most basic, arbitrage can be defined as the concurrent purchase and sale of similar assets in different markets in order to take advantage of price differentials.
When a trader uses arbitrage, they are essentially buying a cheaper asset and selling it at a higher price in a different market, thereby taking a profit without any net cash flow.
Theoretically, arbitrage requires no capital and involves no risk but, in reality, attempts at arbitrage will involve both risk and capital..
How Arbitrage Opportunities Occur
The Efficient Markets Hypothesis in the economic theory suggests that financial markets, including all investors and other active participants, will process all the information available to them with regard to asset values, quickly and efficiently. This would allow for very little room for price action discrepancies to occur across various markets.
In practice, however, markets are never 100% efficient all the time due to the prevalence of asymmetrical information between the buyers and sellers within the market. An example of this inefficiency is when a seller’s asking price for an asset is lower than a buyer’s bid price. This situation is known as a “negative spread”, and is one of the main reasons for the appearance of arbitrage opportunities.
What Is Currency Arbitrage?
Currency arbitrage occurs when financial traders use price discrepancies in the money markets to take a profit. For instance, interest rate arbitrage is a popular way to trade on arbitrage in the currency market, by selling currency from a country with low-interest rates and, at the same time, buying the currency of a country that pays high-interest rates. The net difference in the two interest rates is the trading profit. This method is also known as “Carry Trade”
Another form of currency arbitrage that investors use is known as “cash and carry.” This involves taking positions on the same asset within both the spot market and futures market simultaneously.
In this strategy, an investor will buy a currency and will then short the same currency in the futures market. Here, the trader is taking advantage of different spreads offered by different brokers for a specific currency pair.
The different spreads will create a difference in the bid and ask prices, enabling a trader to take advantage of the different rates. For example, if broker A is offering the USD/EUR pair at 4/3 dollars per euro and broker B is offering this pair at a rate of 5/4 dollars per euro, a trader can convert one euro into USD with broker A, and they will then convert the USD back to EUR with broker B, resulting in a profit.