Currency Arbitrage: Definition, Types, Risk, and Examples

What Is Currency Arbitrage?

Currency arbitrage is the practice of buying and selling the same foreign currency pairs instantaneously to profit from minor differences in pricing among brokers. Most often, this strategy exploits a pricing discrepancy between two currencies such as the U.S. dollar and the euro.

In the language of the foreign exchange, or forex, market, the currency trader is taking advantage of different spreads offered by different brokers. This difference between the bid and ask price is an opportunity for currency arbitrage.

Understanding Currency Arbitrage

The use of computers and high-speed trading systems make currency arbitrage possible, but also make it a high-speed game. Large traders watch for differences in currency pair quotes and close the gap quickly.

Currency arbitrage involves the exploitation of the differences in quotes rather than actual movements in the exchange rates of the currencies in the currency pair.

Forex traders typically practice two-currency arbitrage, in which the differences between the spreads of two currencies are exploited. Traders can also practice three-currency arbitrage, also known as triangular arbitrage, which is a more complex strategy.

The most important risk that forex traders must deal with while arbitraging currencies is execution risk. The risk is that that the desired currency quote may be lost due to the fast-moving nature of forex markets.

Example of Currency Arbitrage

For example, two different banks (Bank A and Bank B) offer quotes for exchanging U.S. dollars for euros. In the forex, this is known as a US/EUR currency pair.

Bank A sets the rate at 3/2 dollars per euro, and Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the trader would take one euro and convert it into dollars with Bank A and then back into euros with Bank B.

The result is that the trader who started with one euro now has 9/8 euros. The trader has made a 1/8 euro profit if no trading fees are taken into account.

Risks and Pitfalls

Currency arbitrage is considered to be risk-free. That is, if the two trades occur simultaneously, there is no possibility of the prices changing.

With the advent of online portals and algorithmic trading, arbitrage has become much less common. The opportunity to identify and act upon price discrepancies before they disappear is simply too brief.

The Bottom Line

Arbitrage trading, particularly in currencies, is made possible by the many financial markets open around the world. It's all about exploiting tiny discrepancies in the prices of assets.

It has become more difficult in recent years due to the extreme speed of modern trading. But institutional traders using sophisticated algorithms are still able to pinpoint and exploit these tiny price discrepancies to make a profit.