Arbitrage operations in the foreign exchange market. Currency arbitrage
06/14/2017 ·
The arbitration technique itself is as old as time.. It functions equally both in the field of small business in rural areas and in the high-tech sector of stock trading. This is a phenomenon that is based on information delay. For some, it entails making huge profits due to the fact that there is an understanding of what is happening; for others, this subsequently becomes a reason to reproach themselves for haste. One way or another, the one who has this information earlier has a great advantage, and this is true for almost any type of activity, but in the area where work is being done with financial instruments, especially.
Here we can draw some analogy between arbitrage in Forex and insider information, which is known to be prohibited for use in trade, liability is provided. But, unlike insider trading, arbitrage is absolutely legal; moreover, there are schemes that are actively used by major players and generate a certain income. All this is paid for by an ordinary ordinary trader, to whom the results of such activities come in the form of changed quotes, slippage, and low liquidity at certain points in time. Let's try to figure out what currency arbitrage is and how it can be used to make money.
Forex arbitrage
In order to understand what it is, you first need to explain how the entire currency trading system functions and how it differs from the rest. If you look at the quotes of shares listed on the stock exchange, you will notice that they are the same on both the London Stock Exchange and the Frankfurt Stock Exchange at a time when both stock exchanges are operating. At first glance, this seems absolutely normal and the fact that it could be different is surprising. The thing is that trading in shares is centralized, that is, there is a connection between trading platforms, hence the absence of different prices. That is, the same paper is presented in both London and Frankfurt at the same price at each point in time.
The foreign exchange market is essentially decentralized. The well-known ECN accounts are actually simply combined into more large networks, which together represent the so-called pools. And from these pools a larger trading network is built. But there is no complete connection between them all, therefore during periods of very strong price fluctuations (for example, the announcement of the results of the Brexit referendum or the decoupling of the Swiss franc from the euro) leads to the fact that different liquidity providers (large associations of ECN networks) get different results on extremes, this in turn is reflected in the quotes from the final large consumer - the broker. And these are the quotes he sees. By the way, not entirely honest companies actively take advantage of this, drawing what is convenient for them. But this is only possible during periods of really very strong and rapid fluctuations; this happens less than once a year.
High volatility days are ideal for using arbitrage
In connection with this method of obtaining quotes, currency arbitrage becomes possible. If there is a delay in receiving signals or any pattern in the differences in quotes between brokers, this is used to make money. Conventionally, we can say that arbitrage in Forex for the most part is making a profit from the imperfection of the trading system, equipment. And much less often is some thoughtful use of trading algorithms in relation to ordinary instruments, albeit different from each other. If you intend to use currency arbitrage, then first of all you should evaluate your capabilities, the quality of the communication channel, track the history of quotes and see how it works in demo mode, that is, fully test the system.
Types of currency arbitrage
On this moment there is only four main options application of arbitrage in Forex. The first three relate to the technical side of the issue, the last, fourth, can be called the most substantiated and intellectual. But this should not influence the choice in any way - everyone earns as much as they can, and taking advantage of flaws in the operating system of their dealing center is not at all a shameful activity, because, as practice shows, brokers themselves often try to deceive their clients. But in the case of currency arbitrage, there is no deception, there is an exploitation of the vulnerabilities of the system itself.
1. Double currency arbitrage. Based on the difference in quotes from different brokers. That is, you need to find a pair of brokers such that, taking into account the spread and commission in the case of an ECN account, there is a difference of at least 0.1 points. For example, at dealing center 1 at a given time the Ask price for the EUR/USD pair is 1.30100, and at dealing center 2 the Bid price for the same trading instrument is 1.30130. That is, in fact, the purchase price from the first office is significantly lower than the sale price from the second. This can be used by concluding transactions in both at once, one to buy at a lower price, the second to sell at a higher price. This method can be turned into a very profitable business if you can find dealing centers that meet the requirements of the currency arbitrage system.
Just 10 years ago, this approach to Forex arbitrage was quite workable, but now brokers themselves constantly monitor competitors’ quotes and it’s practically impossible to find such a big difference. By large we mean at least more than 0.1 points. So as not to work in vain. Basically, all the differences come down to the fact that there are brokers with an adequate spread, say, 1 point on the main trading pair EUR/USD during the European and first half of the American session, and there are those for whom it is fixed at 3 points throughout trading day. That is, the difference in quotes is formed by widening the spread due to poor-quality supply of liquidity, or the greed of such a company.
2. Currency arbitrage based on delay (or single). In this case, the trader doesn’t even have to think; the most important thing is to also find a couple of brokers with a certain condition. One of them must have fairly recent and current quotes, while the second needs a delay. Sometimes it turns out that even half a second of delay in the receipt of a signal can lead to significant losses, anyone who trades news knows this. Accordingly, if you managed to find such a pair, then, in fact, all that remains is to look at what is happening with the “fast” broker and use arbitrage on Forex itself with the slow one.
If the price goes up, we immediately buy, if it goes down, we sell. But this is in theory. But in practice, this is extremely difficult to encounter; usually, small offices that have not yet managed to grow to a significant size and use not the most advanced equipment or low-quality liquidity providers are lagging behind. And in this case, you can expect constant requotes, slippages, delays and other delights that are usually characteristic of all offshore kitchens, not even in the context of currency arbitrage, but in ordinary short-term trading.
3. . Very simple circuit, which should be clear to anyone who has even the slightest understanding of fractions. Let's say there are three currency pairs - GBP/USD, AUD/USD and GBP/AUD. There are three currencies here, which are determined by the behavior of all three pairs. Knowing the quotes for two of them, you can easily calculate what the current value is for the third. To do this, you just need to divide one by the other. But practice does not always agree with what should be in theory. You can see amazing phenomena when two of three such pairs are actively moving, and not in different directions, but completely randomly and unpredictably, while the third at this time seems to have frozen and practically does not move. It is at such moments that currency arbitrage should be used. This is not so easy to do, you will have to calculate the value, look for the “incorrect quote”, a third-party terminal with quotes from another broker, or some service that provides such information, can help with this.
Earnings due to the difference in quotes between three currencies
For greater convenience, they usually use ready-made or ones that are already fully prepared to search for such absurdities in quotes and understand how to use this to carry out currency arbitrage. A robot can do this quickly, efficiently and accurately, but a person is not immune from this and is certainly inferior to a computer in the speed of processing numerical information. Therefore, if there is a specific justification in the form of numbers that a similar technique is applicable to the chosen broker, you can look for an advisor (there are a large number of programs specifically for Forex arbitration) and start making money on this technical imperfection of currency trading.
4. Currency arbitrage on different types tool. This type of currency arbitrage can only be carried out if you have access to futures trading. This is a separate category of instruments that has its own “expiration date” - after which expiration occurs and the contract ceases to exist, and a new one appears in its place. A futures is a contract with deferred delivery; its price usually differs from that offered on the spot market. It is on this difference that it is proposed to make money, since as the expiration date approaches, it can begin to shrink quite noticeably, the spread between these two pairs will decrease, with oppositely directed transactions this leads to the fact that, regardless of where the trend is directed, it will turn out ultimately profit.
Currency arbitrage is operations with currencies, with the simultaneous opening of either identical or opposite positions that differ in terms, both in one or several interdependent markets, with the aim of guaranteed profit through the quotation difference.
Currency arbitrage, in its historical meaning, is a currency transaction that combines the purchase or sale of currencies, followed by a counter transaction in order to make profits at the expense of or from their difference during certain time periods.
What is the expression - currency arbitrage and how to implement it?
What is currency arbitrage? If we apply the law of one price to financial markets, then it can be formulated approximately like this: in all countries the exchange rate of a particular currency is approximately the same.
Unlike time arbitration, spatial arbitrage creates a closed currency position, because In a variety of markets, both selling and buying occur simultaneously, so there is little currency risk.
Under modern conditions of development of electronic media and communications, as well as in connection with the expansion of the volume and number of transactions currency transactions, differences in rates on individual currency markets began to appear much less frequently, for this reason spatial arbitrage lost its importance and gave way to temporary arbitrage.
Varieties and types of currency arbitrage depending on the purpose and methods of implementation
Currency arbitration, among other things, differs in the purpose of its implementation, these are:
- speculative type of arbitrage
- and conversion.
In speculative arbitrage, the goal is to extract benefits (profits) from due to their fluctuations. Note that in this case the final and source currencies must match, in other words, the transaction takes place, for example, according to the following scheme:
- EUR/USD;
- USD/EUR.
Conversion type of currency arbitrage, pursues the goal of the most profitable acquisition of the necessary currency. In other words, currency conversion arbitrage is the use of competitive quotes from different banking institutions in either one or more currency markets. The possibilities of this type of arbitration are wider, because The exchange rate difference here is not so large compared to speculative arbitrage, where it should not only cover the margin between the rates of sellers and buyers, but also generate income.
Under modern conditions, exchange rates on different markets trading currencies very rarely have deviations by an amount that is equal to or exceeds the exchange rate difference between those selling and buying, which makes it possible to use in practice only the conversion type of arbitrage, i.e. banks purchase the currencies they need on those foreign exchange markets where they are cheaper.
Thanks to modern information tools, you can easily monitor all leading currency markets.
At the same time, overhead costs for communications have decreased significantly and, given the increased minimum volume of transactions (min. $5 million and even more), are no longer as significant as before. The technique of currency arbitrage also has its own variations.
According to the technique of implementation, currency arbitrage is divided into the following types:
Interest arbitrage. This type involves the flow of capital to those countries where interest rates are quite high.
This type of arbitrage is closely related to operations carried out on the loan capital market, and also involves obtaining loans in the markets of other countries where interest rates are lower.
Interest arbitrage also involves placing the equivalent of borrowed currencies on national capital markets, where interest rates are higher. Note that banks can enter into agreements on the sale of loan currency for a certain period in order to protect themselves from currency risks;
Equalizing arbitrage. This type involves making a profit from.
Such currency arbitrage can be either direct, i.e. use the exchange rate difference between the currencies of creditors and debtors, and indirectly, i.e. with the participation of a third currency, purchased at the lowest rate and then sold instead of payments;
Differentiated arbitrage. This type of arbitrage involves the use of price differentiation in different currency markets.
At the same time, there is no currency risk or open positions. Unlike those who speculate, arbitrageurs risk much less; as a rule, they open opposite positions in one currency both in one and in several currency markets that are interconnected, thereby reducing exchange rate risks for themselves;
Currency interest arbitrage is a type of simple interest arbitrage and is based on the use by banking institutions of the difference in interest rates for operations that are carried out in different time parameters.
This type of arbitration may be temporary, i.e. used for a certain period of time, covered (forward coverage) and uncovered, in other words without forward coverage.
In conclusion, we note that arbitrage operations for the entire financial market have sufficient great importance. Due to the fact that arbitrage transactions are based on profiting from differences that exist both within one market and between different markets, the intervention of arbitrageurs makes it possible to regulate the market and ensure the relationship between exchange rates.
Opinions of professional traders: When to sell cryptocurrency?
In relation to foreign exchange markets, the law of one price is formulated as follows: the exchange rate of a currency is approximately the same in all countries. The deviation of the exchange rate in various foreign exchange markets is determined by the amount of transaction costs associated with the transfer of a given currency from one foreign exchange market to another. Thus, the dollar exchange rate in New York differs from the dollar exchange rate in Tokyo by the amount of transaction costs associated with transferring the dollar from New York to Tokyo. If exchange rates differ by the amount
greater than the amount of operating expenses, the opportunity arises to play on exchange rate differences, which is called currency arbitrage.
Currency arbitrage is an operation with currencies, consisting of the simultaneous opening of equal (or different) opposite positions in one or more interconnected financial markets in order to obtain a guaranteed profit due to the difference in quotes.
Arbitrage transactions are small in percentage terms, so only large transactions are profitable. They are carried out mainly by financial institutions. The basic principle of arbitrage is to buy a financial asset at a lower price and sell it at a higher price. A necessary condition for arbitrage operations is the free flow of capital between different market segments (free convertibility of currencies, the absence of currency restrictions, the absence of restrictions on the implementation of certain types of activities for various types of agents, etc.). The prerequisite for the operations under consideration is the discrepancy between the quotations of financial assets in time and space under the influence of market forces.
There are temporary currency arbitrage and spatial currency arbitrage. In addition, each of them is divided into simple and complex (or cross-course, triple). Simple arbitration is performed with two currencies, and cross-rate arbitration is performed with three or more currencies.
Local, or spatial, arbitrage involves generating income from the difference in exchange rates in two different markets. An opportunity for local arbitrage exists if the buying rate of a currency at one bank is higher than the selling rate at another bank. Complex arbitrage can occur when the calculated cross rate between two currencies differs from the actual quoted rate by any bank or market. Time arbitrage is an operation aimed at making a profit from differences in exchange rates over time.
In modern conditions, currency arbitrage is giving way to interest and currency-interest arbitrage, since in the foreign exchange markets, after almost two decades of sharp fluctuations in exchange rates, there is a relative equalization of the terms of exchange both between European monetary units and in the relations between them and the US dollar. However, there is a difference in interest rates due to the inconsistency of national policies in the field of interest rates, although integration processes are increasing in the capital markets. Currency arbitrage is based on the use of differences in interest rates on transactions carried out in different currencies. In the most simple case this operation represents the conversion of national currency into foreign currency, placing it on deposit in a foreign bank, after the end of which the funds are transferred back to national monetary units.
Such operations can be carried out in two forms - with and without forward coverage.
Covered interest arbitrage is most often used when playing with exchange rates. Covered interest rate arbitrage is a transaction that combines foreign exchange and deposit transactions, which are aimed at arbitrageurs adjusting the currency structure of their short-term assets and liabilities in order to profit from differences in interest rates across different currencies. As an example of interest rate arbitrage with forward coverage, the following scheme of actions can be given: buying currency at the spot rate, placing it on a time deposit and simultaneously selling it at the forward rate. This operation does not bear currency risk, and the source of profit in this case is the difference in the levels of income received due to the difference in interest rates on currencies and the cost of insurance of currency risk, determined by the size of the forward margin.
Non-bank foreign exchange market participants sometimes use interest rate arbitrage without forward coverage. This transaction is usually medium- or long-term and involves the movement of capital. Its essence is that arbitration? buys currency on spot terms with its subsequent placement on deposit and reverse conversion at the spot rate upon expiration of its validity period. For participants engaged in this type of arbitrage, it is important to correctly assess the trend of changes in the exchange rate over a medium- and long-term period of time, since their currency position is open and thereby exposed to the risk of changes in the exchange rate.
Arbitration operations are the main ones in the work of commercial bank dealers. Often the opportunity for arbitrage transactions arises only for a matter of minutes, so
The bank's profit on any given day largely depends on the dealer's ability to instantly evaluate and calculate an arbitrage operation. Arbitrage transactions are complex and require good market vision, so dealers specialize in transactions in a certain number of currencies.
Arbitrage transactions are also of great economic importance for the entire financial market. Since arbitrage operations are based on capitalizing on the differences that exist between markets or, in the same market, between the terms of contracts, the intervention of arbitrageurs allows for the interconnection of rates and regulation of the market. Unlike speculation and hedging, arbitrage contributes to the short-term equalization of rates in various markets and smoothes out sharp market fluctuations, increasing market stability.
Another operation that is often used by large participants in the foreign exchange market is speculation - an activity aimed at making a profit due to the difference in the rates of financial instruments over time. The success of speculation depends on the accuracy of forecasts, since the implementation of a speculative strategy requires its participant to buy foreign exchange instruments when rates are expected to rise, and to sell when they are expected to fall, the best way taking advantage of the leverage created by the security deposit and the volatility of quotes.
Speculative operations significantly increase the liquidity of the derivatives market. About 60% of all transactions are concluded in the futures market in the hope of speculative profit. This allows for large-scale operations. In addition, speculation creates a fundamental opportunity for hedging, since the speculator, for a fee, consciously assumes the risk of changes in the prices of financial assets, which are transferred to him by hedgers. Thus, hedging is impossible without speculation.
The object of the foreign exchange market is a freely convertible currency. About 80% of all foreign exchange transactions are carried out in the interbank segment of the foreign exchange market - the spot market.
The spot market is a market for the delivery of currency within 2 business days banking days without accruing interest on the amount of currency supplied. Base quotes are set by market makers (usually commercial banks).
A direct quotation of a foreign currency is an expression of the price of a foreign currency in units of the national currency.
Inverse (indirect) quotation is an expression of the price of the national currency in units of foreign currency.
The cross rate is the relationship between two currencies, which is derived from their rates in relation to a third currency.
In the foreign exchange market, urgent operations are those related to the supply of currency for a period of more than 3 days from the date of its conclusion. The rate of futures transactions differs from the spot rate by the amount of discounts and markups from the spot rate, the size of which is determined by the difference in the levels of interest rates on deposits in the respective currencies.
By buying and selling currency for a period, participants in the foreign exchange market adjust their currency position - the ratio of claims and obligations for a certain currency. A currency position can be open or closed. A closed currency position implies a coincidence of claims and obligations in currency; otherwise the position is open. An open position can be “long” or “short”. A "long" position indicates that the claims on some purchased currency exceed the liabilities on it. A "short" currency position assumes that the market participant's obligations exceed the requirements for the currency in question. Having an open currency position is associated with currency risk.
Currency risk is the risk of loss or shortfall in profits in domestic currency due to unfavorable changes in the exchange rate. Participants in both the spot and derivatives markets are exposed to currency risk. Most foreign exchange market participants are hedgers. They protect their foreign exchange earnings from exchange rate risk by closing open currencies
new positions. Speculators consciously take on currency risk by maintaining an open currency position. Arbitrageurs take on currency risk by taking opposing positions in the same currency for different (identical) periods in one or more interconnected markets. Traders buy (sell) currency on behalf and at the expense of the client on the trading floor of the exchange, receiving commissions from clients for this.
A forward foreign exchange contract is a binding agreement to buy or sell on a specified date in the future a specified amount of foreign currency. The currency, amount, exchange rate and payment date are fixed at the time the transaction is concluded. A forward contract is a banking contract; it is not standardized and can be tailored to a specific transaction. If the forward rate is greater than the spot rate (FR > SR), then the currency is quoted at a “premium”; if the forward rate is less than the spot rate (FR A swap transaction is a foreign exchange transaction that combines the purchase and sale of two currencies on the basis of immediate delivery with a simultaneous counter-transaction for a certain period with the same currencies. It does not create an open currency position and temporarily provides the client with currency without risk associated with changes in its course.
Futures and options are primarily traded on an exchange. That is why they are strictly standardized contracts, which is their main difference from forwards and swaps.
An option is a security that gives its owner the right to buy (sell) a certain amount of currency at a price fixed at the time of the transaction at a certain point in the future. The obligation to fulfill the terms of the transaction is imposed only on the seller of the option, while the possible loss of the buyer of the option is limited by the amount of the option premium. A call option gives its owner the right to buy a specific asset in the future at a price fixed at the present time. A put option gives the right to sell a currency under the same conditions. European options can only be exercised on the expiration date of the contract; American options - any time before the expiration date of the contract.
Spatial currency arbitrage involves generating income due to the difference in exchange rates in two different markets, and temporary currency arbitrage - due to the difference in exchange rates over time. Currency interest arbitrage is based on the use of differences in interest rates on transactions carried out in different currencies. It can be carried out with or without forward coating.
TEST QUESTIONS AND TASKS
1) What is meant by the foreign exchange market? What is its structure?
2) What is a currency quote? What types of quotes do you know? What are the rules for calculating the cross rate?
3) Describe the spot and forward markets. What determines the spot and forward rates?
4) What does the quote 5.6342 FRF/USD mean? Name the "big figure" in this quote, the basis point, the quote currency, and the quote base.
5) What is meant by the currency position of a foreign exchange market participant? If a bank buys German marks for Swiss francs, how will its foreign exchange position change?
6) How do futures contracts differ from forward contracts?
7) What transactions in the foreign exchange market are called swap transactions? What are their advantages over other forward transactions?
8) What is the fundamental difference between option contracts and other futures contracts? What types of options do you know?
9) What is the difference between arbitrageurs, hedgers and speculators operating in the foreign exchange market?
10) You are a bank dealer. If the following currency quotes are currently available:
USD/ECU FRF/USD BEF/USD DEM/USD USD/GBP 1.3560/80 5.5500/50 30.45/70 1.5200/70 1.7860/900,
then what quote will you use:
a) sell BEF to the client for USD;
b) buy ECU for USD;
c) buy DEM for FRF;
d) sell GBP for BEF?
In addition, answer at what quote the bank client will buy GBP from you for ECU. 11) Determine how many German marks there are per SDR unit if the following information is available (table). Currencies Share in the SDR basket in national terms Exchange rate in dollars for each currency unit US dollar 0.452 1.0000 German mark 0.527 0.6442 Swiss franc 0.875 0.7841 French franc 1.02 0.1886 Japanese yen 33.4 0.0102 Pound sterling Danish krone 0.089
0.1641 12) If you were the holder of a call option in US dollars at a trade rate of 1.70 USD per 1 GBP, then you would exercise the option at a spot rate of 1.83 USD per
13) The following information is available on the DEM/USE rate (table): Exchange rate Buy Sell Spot rate Swap rate (30) 1.6700 50 1.6780 40 What will be the forward 30-day sale rate of DEM/USD?
Today the value of the stock market is Russian economy is growing rapidly, especially for entrepreneurs of various levels. But the basis of a large number of operations in the stock market is nothing more than arbitrage. Arbitration operations are of great economic importance for the entire financial market. Since they are based on capitalizing on the differences that exist between markets or in the same market between contract terms, the intervention of arbitrageurs allows for the interconnection of rates and regulation of the market. Unlike speculation and hedging, arbitrage contributes to the short-term equalization of rates in various markets and smoothes out sharp market fluctuations, increasing market stability. So, this article discusses in detail, as well as the corresponding principles. How should this concept be understood? What is its significance in economics Russian Federation Today? What is this connected with?
Currency arbitration: concept and essence
Today, the basis of a large number of operations in the securities market is arbitrage. It represents the extraction of income through the repeated sale of securities subject to more favorable prices. However, it should be remembered that arbitrage involves not only carrying out some operations on the stock market. In a broad sense, the concept can be interpreted as the purchase of a particular product at an extremely low price and its sale on another market, respectively, at a high price at the same time. Obviously, the result of the above activity is nothing more than the profit received.
Arbitrage operations are divided into two main types: stock and . This article mainly discusses the latter (by the way, its other name is interest rate arbitrage).
Under currency arbitrage in the markets Money one should understand the movement of these resources directly from the currency of one country to the currency of another. It is important to add that its main goal is to improve conditions in the process of borrowing or lending. In fact, the type of arbitrage operations under consideration one way or another consists in determining a country or currency with an extremely favorable interest rate on a loan. It is interesting to know that the financial instruments in the case of currency arbitrage are usually government bonds or bank deposits. By the way, today there is such a thing as the uncovered type. Such transfers occur when the movement of funds from the currency of one country to the currency of another implies, one way or another, the presence of a corresponding risk.
Risk in arbitrage operations
As it turned out, uncovered currency arbitrage involves there is some risk. Thus, if a certain speculation in relation to a currency is nevertheless justified, then the risk that is directly associated with the combination of an open position in a currency with interest rate arbitrage gives the corresponding entity the opportunity to receive an additional profit. Naturally, the latter significantly increases the winnings obtained thanks to the percentage arbitrage itself.
It is important to note that in the event of a parity violation, an arbitrage situation occurs. Thus, currency contacts can easily arbitrage directly against bank interest rates on deposits and the spot rate. It is clear that the potential profit from this type of operation practically ignores movements in interest rates, but feels even the slightest fluctuations in exchange rates.
Currency Arbitration: Principles
As it turned out, under currency arbitrage, in accordance with its historical significance, one should understand operations with currency that combine the purchase or sale of it subject to a subsequent counter-transaction. The main goal is to make a profit directly from exchange rate fluctuations or currency differences over a certain period of time. When applying the law of one price in relation to financial markets, it can be formulated as follows: in absolutely all countries of the world, the exchange rate of a particular currency is approximately the same. The deviation from the norm of exchange rates in various relevant markets determines nothing more than the amount of expenses in relation to various operations. The latter are usually associated with transfers of these currencies from one market to another.
How does it happen in practice? currency arbitrage? Implementation technique assumes that, for example, the US dollar exchange rate in Tokyo, one way or another, will differ from the US dollar exchange rate in New York directly by the amount of expenses for the corresponding operations. The latter, as already noted, are primarily associated with the transfer of this currency from the United States of America to Japan. If cases arise when the exchange rate differs from another by a significant amount (compared to the implementation of purely operating expenses), then, one way or another, it becomes possible to carry out operations of a speculative nature, playing on the difference in this rate. So, currency arbitrage is exactly this kind of action.
Features of arbitration operations
It is important to note that arbitrage operations in percentage terms are not large at all. That is why arbitrage in the foreign exchange market beneficial only when carrying out large-scale transactions. The implementation of the latter, as a rule, is carried out through the largest institutions directly related to financial activities.
The fundamental principle of arbitrage is the acquisition of a financial asset at a lower cost and, accordingly, its sale at a high cost. It should be noted that this is carried out only if the following factor is observed: ensuring the free flow of capital directly between different market segments. In other words, this is the absolute absence of currency restrictions and limits in terms of the implementation of certain types of activities for various types of agents. In addition, this also includes free convertibility, which is important in relation to the issue under consideration. The technique according to which it is carried out indicates the presence of some discrepancies in the quotes of financial instruments. This position relates to both space and time.
Classification of currency arbitrage
Today it is customary to distinguish the following types of currency arbitrage:
- Temporary currency arbitrage. It is important to add that this type is classified into simple and complex arbitration. The second is often called indirect.
- Spatial currency arbitrage.
In the case of simple currency arbitrage, the necessary actions are carried out in relation to two currencies, subject to cash and forward transactions. In complex arbitrage, the corresponding transactions are carried out with three or more currencies. It must be added that complex one way or another involves raising brokers up imaginary steps. In this case, it is as if the purchased currency units are being exchanged for third, fourth, fifth, and so on. It must be added that final stage The above actions do not necessarily require returning to the original currency.
Currency arbitrage complex type can be done when the cross rate calculated directly between two different currencies differs in some way from the actual quoted rate on a particular market or in one of their banking institutions.
Types of arbitration and their features
As it turned out, today there is a distinction between temporal and spatial currency arbitrage. The latter, as a rule, is used directly for the purpose of making a profit precisely due to the difference in exchange rates on different currency markets. Temporary arbitrage implies that exchange rate profits are formed due to changes in the exchange rate over a certain period of time. Thus, this type is closely related to the category of currency risk. It is important to add that interest rate arbitrage is a type of currency arbitrage. In the case of the latter, profit appears directly due to the difference in exchange rates and interest rates.
It should be noted that in the process of development of the monetary and global system, the types and forms of currency arbitrage also changed. Thus, during the period of the “gold standard,” the practice of currency arbitrage was widely known, which primarily depended on the exchange rate difference of bills, gold, currencies, as well as all possible means of credit and payment. However, somewhat later, the significance of gold arbitrage was lost. Why? The main point is that the “gold standard” ceased to operate, and the spatial standard, in spite of everything, continued to be actively used, since due to the not very fast and reliable connection directly between the foreign exchange markets, the existing difference in the dynamics of exchange rates remained .
Main differences
What else are the differences between time arbitration and spatial arbitration? Compared to the time type, in the case of spatial arbitrage, a closed position is formed in terms of currencies. Why? The fact is that in different currency markets both the acquisition and sale of relevant objects are simultaneously realized. Thus, a large currency risk cannot logically arise.
Thanks to modern conditions the development of electronic information tools, as well as due to the expansion in the number and volume of currency transactions, differences in exchange rates on individual foreign exchange markets began to appear much less frequently. It is for this reason that spatial arbitration has completely lost its own meaning, which means it has given way to temporal arbitration.
Types depending on purpose
In addition to the above classification, today there is a division of currency arbitrage into types depending on the purpose of implementation:
- Speculative currency arbitrage.
- Conversion currency arbitrage.
In the case of the first of these currency arbitrages, the main goal pursued is to benefit (in other words, to obtain a certain amount of profit) directly from the difference between exchange rates. The reason for this is nothing more than the fluctuation of the latter. It should be noted that in this case, the source and final currencies must match, that is, the transaction is carried out approximately according to the following scheme: EUR/USD; USD/EUR.
In the case of the second of the presented types of currency arbitrage, the key pursued goal is the extremely profitable purchase of a certain currency, which is necessary directly for the subject of the relevant activity. In other words, conversion-type currency arbitrage is nothing more than the use of competitive quotes from various banking structures either on one or some of the foreign exchange markets. It is important to add that the possibilities of this type of arbitration are much wider. Why? The fact is that the exchange rate difference in this case is not so large compared to speculative arbitrage, where, as a rule, it not only covers the marginal profit between the exchange rates of buyers and sellers, but also brings, one way or another, a certain amount income.
Conversion operations
Today, conversion operations are referred to as such operations for the acquisition and sale (conversion, exchange) of pre-agreed currency amounts of one country directly into the currency of another country or the corresponding amount of international monetary units(for a specific date). In modern times, conversion operations are defined using the term “Forex”. It is important to add that in relation to the world foreign exchange market, conversion transactions of an interbank nature predominate.
It should be noted that in modern times, exchange rates in various markets that trade in the corresponding product very rarely have some deviations by a value equal to or greater than the difference between buying and selling rates. This provision, of course, makes it possible to use exclusively currency conversion arbitrage in practical terms. In other words, banking institutions buy the currencies they need directly from those markets where their value is lower.
Thanks to innovative information tools, today you can effortlessly monitor absolutely all changes in currency quotes on leading foreign exchange markets. Assuming certain currency arbitrage indicator also speaks of the existence of overhead costs related directly to communications. The important thing is that in this case they were significantly reduced. Thus, in the context of a significantly increased minimum volume of transactions, these costs are no longer felt as much as before.
Classification by implementation technique
In accordance with the implementation technique today, currency arbitrage is classified into the following types:
- Interest rate currency arbitrage. This type indicates the flow of capital directly into those states where interest rates are significant in their magnitude. It is important to note that interest rate arbitrage is closely related to actions taken in the markets of other countries, where interest rates are much lower. In addition, this type in any case involves the placement of the equivalent of borrowed currencies on national financial markets. The latter, of course, have higher interest rates. It should be noted that banking institutions are given the right to enter into an agreement on the sale of a foreign currency loan for a specific period of time in order to ensure protection against risks of a currency nature.
- Equalizing currency arbitrage. This type refers to the use of price differentiation in order to obtain a certain amount of profit. This kind of currency arbitrage can be direct or indirect. In the first case, it is appropriate to use the exchange rate difference between the currencies of debtors and creditors. In the second, there is the participation of a third currency, purchased at an extremely low rate and sold later instead of payments.
- Differentiated currency arbitrage. This type indicates the use of price differentiation in different currency markets. At the same time, there are no open positions and no currency risk at all.
- The currency-interest type of arbitration is nothing more than a type of simple interest arbitrage. It is based mainly on the application by banking structures of the difference in interest rates on those foreign exchange transactions that are carried out in accordance with different time frames.
Currency arbitrage
Currency Arbitrage is the simultaneous purchase and sale of currency from different Forex brokers or dealing centers in order to obtain a guaranteed profit. In simple words, the trader analyzes quotes in different dealing centers, or rather the threshold for a certain number of points between the Ask and Bid prices. As in the case of regular trading, after opening both positions will be in the red by the amount of the spread, which means that for the transaction to be at least break-even, a threshold of 2 spreads is required. Arbitrage trading is also possible in other financial markets, however, in Forex it is the most profitable due to the significant difference in quotes in most brokerage companies.
Brokers are well aware of arbitrage trading and do their best to prevent it. The main restrictions include a ban on pips and a time limit on an open transaction. Sometimes a situation arises when a position is opened at one Forex broker, and at another there is a requote for the same currency pair. If this happens several times, all profits from arbitrage are wiped out.
If you delve deeper into the concept of currency arbitrage, it is quite extensive. There is simple and complex arbitrage, where in the first case two currencies are used for trading, and in the second - three or more. This type of trade changed along with the development of the monetary system. At a time when the amount of state currency was provided by gold reserves, traders looked for differences in the rates of bills, precious metals, and loan obligations. When the backing of money in gold was abolished in the 30s of the last century, only currency arbitrage remained relevant, since the information connection between markets was quite weak. A scheme was practiced with the participation of two people who were spatially located in different markets and, by agreement, entered into transactions in different directions. With the development of Internet technologies, exchange rate differences began to occur less frequently; today only temporary arbitrage is profitable.
Exist different kinds targeted currency arbitrage, such as speculative and conversion. The first involves making a profit through constant changes in exchange rates, that is, it is a mechanical purchase and sale of currencies with a quotation difference. Conversion gives more opportunities, since its goal is to find the most profitable rate in different markets. Banking institutions and large traders use conversion arbitrage as it is less risky; in this case, there is no need to cover the spread of both transactions.
Large players receive significant profits from currency arbitrage: international banks, investment funds, that is, market makers. With their capital, they create the most favorable state of demand for currency for them. However, there is still risk, mainly related to the likelihood of market changes during arbitration. So, to minimize the likelihood of losing money, traders use powerful computers that allow them to win every second.
Buying a product in one market and immediately selling it in another at a higher price is quite normal. However, to carry out arbitrage transactions, it is necessary to use a universal instrument that is liquid in different markets. If a trader buys security on the New York Stock Exchange, he can sell it only there. In this case, the above operation makes no sense. With currencies, things are different, because offers to buy and sell can be formed in different markets.
In modern realities, a trader must be able to quickly analyze the occurrence of exchange rate differences in order to make a profit. Often a special threshold is used to identify the threshold. software, which allows you to trade simultaneously on several currency pairs. With large trading volumes, even a slight exchange rate difference is enough to make a profit. However, Forex brokers carry out close adjustments, as a result of which exchange rate differences are quickly eliminated.
Transactions involving the physical delivery of goods, such as aluminum, are popular in global trade. Let's assume that it is possible to buy aluminum at a price of $1,800 per ton and sell it abroad at $2,200 per ton to another buyer. Such transactions are also fraught with risk; until aluminum physically reaches the market, its price may drop significantly. Theoretically, currency arbitrage is not subject to such risks, but in practice, much depends on the speed of execution of an order by a Forex broker. For this reason, it is extremely important to use powerful computers and modern software.
One of the most difficult types of currency arbitrage from a technical point of view is interest arbitrage, which is carried out in the debt capital market. The principle of this operation is as follows: the owner of a certain amount of money places it on the credit market in another currency. The conversion is carried out to make a profit from the interest rate margin. The operation, as in the case of the Forex currency market, involves the following transactions: obtaining a cheap loan with a low interest rate on one market and issuing the same loan in converted currency, but on another market with a higher interest rate. For example, the Bank of England issues a loan to the US Federal Reserve at 4% per annum, then converts British pounds into dollars and offers them on another market at 8% per annum. Net profit will be 4% of the amount. When the time comes to repay the loan at maturity, a reverse conversion occurs, i.e., dollars are sold for British pounds.
Currency arbitrage can be used by both private traders and large financial institutions. The scale, complexity of operations, as well as their volume determine the possible income from the transaction. Competent analysis and attentiveness can bring very significant income.