What is arbitrage?
Before talking about arbitrage in forex trading, it is important to define arbitrage in general. Simply put, arbitrage is a form of trading in which a trader seeks to profit from discrepancies in the prices of identical or related financial instruments.
These discrepancies occur when an asset – such as EUR/USD – is being differently priced by multiple financial institutions. This means that arbitrage involves buying an asset at one price from the first financial institution and then almost instantly selling it to a different institution to profit from the difference in quotes.
The speed at which transactions are carried out means that the risk for the trader can be very low. However, there is always some risk with trading, particularly if prices are moving quickly or liquidity is low.
Learn more about forex trading and how it works
How arbitrage trading works
Arbitrage trading works due to inherent inefficiencies in the financial markets. Supply and demand are the primary driving factors behind the markets, and a change in either of them can affect an asset’s price.
Arbitrage traders seek to exploit momentary glitches in the financial markets. They aim to spot the differences in price that can occur when there are discrepancies in the levels of supply and demand across exchanges. As a result, a trader could realise a quick and low-risk profit.
Traders can use an automated trading system to their advantage as part of an arbitrage trading strategy. Automated trading systems rely on algorithms to spot price discrepancies and, as a result, they enable a trader to jump on an exploit in the markets before it becomes common knowledge and the markets adjust.
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Types of arbitrage
There are three main types of forex 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
- Covered interest arbitrage is a trading strategy in which a trader exploits the interest rate differential between two countries, while using a forward contract as a hedge to cover their exchange rate risk
- Triangular arbitrage arises from the differences in price between three different currencies and the conversion of one currency into two others before it is converted back into the first currency – hopefully at a profit
Arbitrage example
We’ll give three examples of arbitrage, each explaining the previous bullet points in greater detail: