Arbitrage

Definition

Arbitrage is the practice of taking advantage of a price difference between two or more markets, striking a combination of matching deals to capitalize on the imbalance and generate a risk-free profit. It is a fundamental concept in foreign exchange markets, where traders exploit small differences in currency prices across various exchanges.

5 Must Know Facts For Your Next Test

1. Arbitrage opportunities in foreign exchange markets arise due to temporary imbalances in supply and demand for different currencies.
2. Arbitrageurs exploit these price discrepancies by simultaneously buying the undervalued currency and selling the overvalued currency, profiting from the difference.
3. Arbitrage helps to promote market efficiency by quickly eliminating price differences and aligning exchange rates across different markets.
4. Covered interest arbitrage involves using forward contracts to lock in the future exchange rate, allowing traders to profit from interest rate differentials between countries.
5. The prevalence of arbitrage opportunities is reduced as markets become more efficient, with traders quickly identifying and exploiting any price discrepancies.

Review Questions

• Explain how arbitrage helps to promote market efficiency in foreign exchange markets.
  • Arbitrage plays a crucial role in promoting market efficiency in foreign exchange markets. When arbitrageurs identify a price discrepancy between the exchange rate in one market and another, they will quickly buy the undervalued currency and sell the overvalued currency. This action helps to eliminate the price difference and align the exchange rates across different markets, ensuring that currencies are priced consistently. The rapid identification and exploitation of these price discrepancies by arbitrageurs ensures that foreign exchange markets remain efficient, with prices that accurately reflect the underlying supply and demand for different currencies.
• Describe the concept of covered interest arbitrage and how it allows traders to profit from interest rate differentials between countries.
  • Covered interest arbitrage is a trading strategy that involves borrowing in one currency, converting the funds to another currency, investing the proceeds, and then using the future value to repay the original loan. This allows traders to lock in a risk-free profit by exploiting the difference in interest rates between the two countries. By using forward contracts to secure the future exchange rate, the trader can eliminate the currency risk and focus solely on profiting from the interest rate differential. Covered interest arbitrage helps to align interest rates and exchange rates across countries, promoting market efficiency and ensuring that capital flows to where it can earn the highest risk-adjusted return.
• Analyze how the prevalence of arbitrage opportunities in foreign exchange markets is reduced as markets become more efficient.
  • As foreign exchange markets become more efficient, the prevalence of arbitrage opportunities is reduced. This is because the rapid identification and exploitation of price discrepancies by arbitrageurs quickly eliminates these discrepancies, aligning exchange rates across different markets. The more efficient the market, the fewer the opportunities for traders to profit from temporary imbalances in supply and demand. In highly efficient markets, any price differences are quickly identified and exploited, ensuring that currencies are priced at their fair value. This increased market efficiency reduces the potential for risk-free profits through arbitrage, as traders are less able to capitalize on temporary price anomalies. The reduction in arbitrage opportunities is a sign of a well-functioning, efficient foreign exchange market.

Related terms

Spot Exchange Rate: The current market price at which one currency can be exchanged for another for immediate delivery.

Forward Exchange Rate: The exchange rate at which a currency can be bought or sold for delivery on a specified future date.

Covered Interest Arbitrage: A trading strategy that involves borrowing in one currency, converting the funds to another currency, investing the proceeds, and then using the future value to repay the original loan, locking in a risk-free profit.