Forex arbitrage is taking advantage of price differences between two different markets. In Forex arbitrage the trader buys in one market and sells in the other. These transactions must occur simultaneously in order to avoid market risk. Forex arbitrage helps keep Forex markets efficient as traders take immediate advantage of small price differences. Thus Forex markets across the world remain synchronized.
In order for Forex arbitrage to work there need to be three factors in sync. A currency pair does not trade at exactly the same price on all markets. The market’s expectations vary from trader to trader and market to market. The current price of a currency as measured in other currencies floats with the market and is not fixed to a futures price or other controlling situation. In addition, trades of two or even three currency pairs must be executed simultaneously. Without immediate, simultaneous trade execution Forex arbitrage becomes subject to market risk.
Practicing Forex arbitrage requires electronic trading as it takes advantage of differences in price in markets across the world. The trader will need a broad band internet connection, appropriate trading software, an account with a broker, and a modern trade station. He will also need to develop the skills necessary to spot price differentials and to promptly execute trades in order to gain profits.
Forex arbitrage is most successful in volatile markets. A recent example is the response of the Yen after the earthquake and tsunami that devastated much of Japan’s Northeast coast. The initial expectation of many was the Yen would fall in value. That was before Japanese investors, banks, and companies starting bringing assets back home to Japan. Using the Yen carry trade many had moved assets overseas to take advantage of favorable interest rates. When the need arose for more cash back home investors sold their stocks, T-bills, and other investments, and bought Yen. The Yen rose precipitously in value until the G 7 financial ministers and various central banks threatened intervention at an announced exchange rate. Those practicing arbitrage during this fall, rise, and adjustment of the Yen saw repeated opportunities for profit.
The primary risk in Forex arbitrage is that of not having trades processed simultaneously in two different markets in two different parts of the world. Because Forex arbitrage is most profitable and therefore most practiced in volatile markets the risk of one transaction going through and the other not being processed can be substantial. Considering the degree of leverage that many traders use to trade Forex there is always as danger of exceeding the size of one’s margin account and getting a margin call. A practical consideration when practicing arbitrage is the stability of the internet connection one uses. Having the internet go down after buying in one market and before selling in another market can be absolutely devastating. The other practical consideration is that there are skill sets to be developed in this sort of Forex trading. Practicing in simulation allows the trader to develop Forex arbitrage strategies as well as the specific skills need to profit from Forex arbitrage.