Tuesday, 31 July 2012

Foreign Exchange: Arbitrage Opportunity (Critical Review)

By Jackie, Researcher
Topic: Education
Area of discussion: Finance
Chapter: Foreign exchange – Arbitrage opportunity

The objectives of this research are to find out how people actually earn money via foreign exchange, how they do that (the steps like what currencies they need to buy and sell), how to make a good use of arbitrage opportunity to earn unlimited profit, how to calculate arbitrage profit (sample questions, examples, and calculations are provided to ease understanding) and the limitation and assumption of arbitrage opportunity in foreign exchange (what conditions must be fulfilled in order for this ‘arbitrage opportunity’ to hold).

Well, in finance, I always heard about “high risk, high return” concept, but this arbitrage concept is totally different. I was really amazed by its concept: No risk, unlimited return (profit is infinity). Ideally, ‘arbitrage’ involving a simultaneous transaction to be entered at the same time, that is, the purchase and sale of currencies at the same time in order to earn ‘arbitrage profit’ due to differences in currencies price quoted in different places (markets). It is a trade where profits are made by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies. The reason why no risk is involved is because transactions are entered simultaneously. There is no delay in time, as time resembles risk and uncertainly in finance. Unlimited profits are possible for an astute (alert and smart) trader by re-entering or repeating those transactions again and again, until the market become efficient or equilibrium.

Triangular arbitrage
Triangular arbitrage (also referred to as ‘cross currency arbitrage’ or ‘three-point arbitrage’) is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market. A triangular arbitrage strategy involves three trades, exchanging the initial currency for a second, the second currency for a third, and the third currency for the initial. During the second trade, the arbitrageur locks in a zero-risk profit from the discrepancy that exists when the market cross exchange rate is not aligned with the implicit cross exchange rate.

Let’s look at this example:

Suppose we observe these banks posting these exchange rates:

  Westpac quote - A$/€  A$1.2223/€
  Barclays quote - A$/£  A$1.8410/£
  Deutsche quote - €/£   €1.5100/£

[One round trip]

Westpac Bank uses A$1,000,000 to exchange to pound at Barclays Bank at A$1.8410/£. This will give Westpac Bank £543,183. This amount is then, exchanged to euro at €1.5100/£ at Deutsche Bank. This will give Westpac Bank €820,206. Finally, this amount is converted back to Australian dollar at A$1.2223/€ in Westpac Bank itself. This will give Westpac Back A$1,002,538.

Arbitrage profit for one round trip: A$2,538.

Condition for arbitrage opportunity:
It is assumed that Interest Rate Parity (IRP) did not hold. If IRP holds, then there will be no more arbitrage opportunity. Besides, transaction costs are normally ignored during calculation. In reality, transaction costs will lower down the arbitrage profit. In addition, it is assumed that no capital controls are involved. Governments sometimes restrict import and export of money through taxes and outright bans.

Interest Rate Parity (IRP)

The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. Ideally, Interest Rate Parity (IRP) is a non-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries.

An illustration when Interest Rate Parity (IRP) holds:

An illustration when Interest Rate Parity (IRP) failed to hold:

Additional readings, related links and references:

This link provides a simple definition and few good examples of arbitrage as well as certain underlying assumptions for arbitrage theory to hold. Good link to view at for new learners or beginners.

An explanation of what is arbitrage and how to use it in the forex market to generate quick, safe, profits.

Step-by-step video tutorial and guides related to the ‘triangular arbitrage concept’ in currency markets.

Triangular arbitrage’s definition and calculation is available in this link. Extremely brief article, but I believe beginners can have a basic understanding about this concept by viewing this (at a glance).

How to calculate currency cross rate and triangular arbitrage calculation to find arbitrage profit is shown in this link.


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