Definition of arbitrage and its types

Sometimes companies deal in foreign exchange to make a profit, even though the transaction is not connected to any other business purpose, such as trade flows or investment flows. Usually, however, this type of foreign exchange activities is more likely to be persuaded by foreign exchange traders and investors. One type of profit  seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) in order to profit from a price discrepancy.  Hence, arbitrage may be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage).

Interest arbitrage involves investing in foreign-bearing instruments in foreign exchange in an effort to earn a profit due to interest rates differentials. For example, a trader may invest $ 1000 in the United States for ninety days or convert $1000 into British pounds, invest the money in the United Kingdom for ninety days and then convert the pounds back into dollars. The investor would try to pick the alternative that would be the highest yielding at the end of ninety days.

But Speculation is the buying or the selling of the commodity i.e. foreign currency, where the activity contains both the element of risk and the chances of a greater profit. Speculators are important in the foreign exchange market because they spot trends and try to take advantage of them. Thus they can be a valuable source of both supply and demand for a currency. As a protection against risk, foreign exchange transactions can be used to hedge against a potential loss due to an exchange rate change.

Spot Quotations:

  • Arbitraging between Banks: Though one hears the term “market rate”, it is not true that all banks will have identical quotes for a given pair of currencies at a given point of time. The rates will be close to each other but it may be possible for a corporate customer to save some money by shopping around.

  • Inverse quotes and 2-point arbitrage: The arbitrage transaction that involve buying a currency in one market and selling it at a higher price in another market is called Two – point Arbitrage. Foreign exchange markets quickly eliminate two – point arbitrage opportunities if and when they arise.

  • Cross rates and 3-point arbitrage: The term three – point arbitrage refers to the kind of transaction where one starts with currency A, sell it for B, sell B for C and finally sell C back for A ending up with more A than one began with. Efficient foreign exchange markets do not permit risk – less arbitrage profit of this kind.

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