“Arbitrage” in Foreign Exchange Market

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Definition: Arbitrage is the process of a simultaneous sale and purchase of currencies in two or
more foreign exchange markets with an objective to make profits by capitalizing on
the exchange-rate differentials in various markets.

The arbitrage opportunities exist due to the inefficiencies of the market.

While dealing in the arbitrage trade, an individual can make profits only out of
price differences of similar or identical financial instruments traded on different
exchange markets. Thus, the price differential is captured as a trade’s net
payoff. This payoff should be large enough to cover the expenses incurred in
executing the trade.

For example: Suppose the stock of company A is trading at Rs 2000 on BSE

while the same stock is trading on NSE at Rs 2500. A trader can earn a profit of
Rs 500 by buying the stock on BSE and immediately selling the same shares on
NSE. This arbitrage opportunity can be availed until BSE runs out of shares of
company A or until BSE and NSE adjusts the price differences so as to wipe out
the arbitraging opportunity.

The importance of arbitrage lies in its ability to correspond foreign exchange

rates in all the major foreign exchange markets. The arbitraging involves the
transfer of foreign exchange from the market with a lower exchange rate to the
market with a higher exchange rate. Hence, arbitraging equates the demand for
foreign exchange with its supply, thereby acting as a stabilizing factor in the
exchange markets.

The arbitrage opportunity can be availed only where the foreign exchange
is free from controls, and if any, controls should be of limited significance. If
the sale and purchase of foreign exchange are under severe control and
regulation, then the arbitrage is not possible. Practically, the arbitrage
opportunity exists for a very brief periodsince in the mature markets the most
of the trading has been taken by the algorithm-based trading (a trading
system that relies heavily on mathematical formulas and computer programs to
determine the trading strategies). These algorithm-based trading are quick to
spot and is quite easy for a trader to keep track.