All About Arbitrage
What is Arbitrage? One of the most asked questions in the finance world. Continue to discover exactly what it is.
To begin with, arbitrage is best defined as a trading strategy in which people seek to exploit price differences. Arbitrage takes place when there are temporarily unusual circumstances present.
Four different types of arbitrage will be examined throughout this article so we, as traders, can get an in-depth understanding of what it truly entails.
Location-based arbitrage is present when a seller’s ask price is lower than another buyer’s bid price, also known as a “negative spread”. An example of foreign exchange is when one bank quotes a particular price for a currency, while at the same time, a separate bank references a different price. In a situation such as this, an arbitrager would yield a profit by simultaneously buying the lower quote and selling the currency at the higher quote.
One key aspect to note is that arbitrageurs generally seek opportunities such as this in today’s swiftly moving market. These opportunities present themselves sometimes only for milliseconds or seconds at a time before the market reaches equilibrium again. Traders in the market participating in arbitrage help correct the market bringing it back to its level, equilibrium and fair state.
Eluding in the title, triangular arbitrage involves three different currencies. The base, quote, and counter currency must coincide with each other to yield a positive implied cross rate for triangular arbitrage to be present. These pairs would be traded amounting to three (or more) trades in total to reach one arbitrageur’s final goal.
Just like location-based arbitrage, triangular arbitrage does not present itself in the market very often and only traders with highly sophisticated algorithms with the capabilities to move at lightning-fast speeds have a chance at this type of arbitrage. Furthermore, these pairs present throughout the tri-trade must match up in size and there are other hidden risks present to decrease the chance of this arbitrage to truly occur.
Interest Rate Arbitrage
Interest rate arbitrage, also called carry trade arbitrage, is when the transaction is completed with the sale being from a low-interest rate country and the buy currency from a high-interest rate country. For this arbitrage to be complete the arbitrager must reverse this process and subsequently would take the net difference of the interest paid on the two currencies at hand. This type of arbitrage is more lengthy than the previous ones discussed.
Also known as cash-and-carry arbitrage, this arbitrage involves carrying out trades in both the spot and future markets with the same currencies. To carry out this arbitrage the trader would buy an undervalued asset and sell, or more commonly known as, shorts the same asset in the futures market. These transactions are done simultaneously. This can also be done in reverse where the seller would sell and then go long on the asset.
One might consider arbitrage trading “risk-free”, but on the contrary; risk will always be present. Arbitrage is not risk-free, but rather speculative in nature. One of the most common types of risks present during arbitrage trading is execution risk. Execution risk is when there is a price tick before the transaction has gone through, the depending factor on this could be milliseconds, or even something as elementary as your internet connection’s strength.
One of the debating questions that still stands is, do arbitrage opportunities still exist in today’s technologically advanced world? With information becoming more and more easily accessible and available, as well as the trading systems becoming more advanced in execution of timing and automated trading systems, opportunities for arbitrage have diminished significantly, but of course, will always be present.