Arbitrage

Arbitrage is the simultaneous purchase and sale of an asset in different markets to exploit price differences for a risk-free profit. It occurs when an asset is priced differently in two or more markets, allowing an investor to buy low in one market and sell high in another.

In currency arbitrage, traders exploit differences in exchange rates between different currency pairs in different markets.

Example: Let’s use three different currency pairs traded in different markets.

1. USD/EUR (U.S. Dollar to Euro)
2. EUR/GBP (Euro to British Pound)
3. GBP/USD (British Pound to U.S. Dollar)

Suppose the following exchange rates are available:

• 1 USD = 0.9 EUR
• 1 EUR = 0.8 GBP
• 1 GBP = 1.5 USD

We start with 1,000 USD and aim to exploit the differences in these exchange rates.

Calculation:

1. Convert USD to EUR:

EUR received = 1,000 USD × 0.9 EUR/USD = 900 EUR

2. Convert EUR to GBP:

GBP received = 900 EUR × 0.8 GBP/EUR = 720 GBP

3. Convert GBP back to USD:

USD received = 720 GBP × 1.5 USD/GBP = 1,080 USD

Calculate the profit:

• Profit: 1,080 USD − 1,000 USD = 80 USD

By exploiting the price differences between these currency pairs, the trader makes a risk-free profit of 80 USD.

Key Points to Note:

1. No Risk: Arbitrage is considered risk-free because the buy and sell transactions are simultaneous, eliminating market risk.
2. Speed: Arbitrage opportunities are often short-lived as market prices adjust quickly due to the actions of arbitrageurs.
3. Costs: Transaction costs, such as trading fees and currency conversion fees, must be considered as they can impact the profitability of arbitrage.