What is Currency Arbitrage?

Currency arbitrage is the simultaneous purchase and sale of a currency to take advantage of price differences in different markets. The transactions generally take place on two or more different markets, and often involve multiple currencies as well. To accomplish the goal of simultaneously buying and selling a currency, the most powerful computers and sophisticated arbitrage software are necessary to identify profit opportunities and take advantage of them. The underlying concept is that currency arbitrage offers the arbitrager — the investor making the trades — the opportunity for a risk-free profit.

Arbitrage itself is the exploitation of price differences in a commodity or investment in different markets, and is a fairly common occurrence, although it's not usually characterized by that term. Unlike investing in equities markets, where an investor hopes to buy low, hold a stock while it increases in value, and then sell high, arbitrage involves buying an asset at one price in the certainty that it can be immediately resold elsewhere for a profit. It can be as simple as buying goods in one neighborhood that one knows are in demand in another neighborhood for a higher price. There is an element of risk, though — market conditions may change in the time it takes to bring the goods from one market to another. Currency arbitrage attempts to eliminate that risk by utilizing powerful computers and software to execute trades simultaneously.

Currency arbitrage in the modern day also requires instantaneous analysis of the prices of most of the world's currencies on a multitude of markets and identifying differences large enough to produce a profit. In many cases, there will be many currencies involved, and each must be either bought or sold at the same time for the profit to be guaranteed. Even apparently minute differences are usually enough to justify an arbitrage transaction. Currency markets, though, are normally self-correcting. As soon as any difference in prices sufficient to justify an arbitrage trade is noticed, it's corrected. This is the main reason the transactions must be simultaneous.

For example, if a dozen eggs sell in one market for $1.50 United States Dollars (USD) per dozen, and in another market for $2 USD, an arbitrager might buy the entire stock from one market in hopes of making a handsome profit at the other. In the time it takes to purchase and transport the eggs, though, many things can happen. The demand in the second market might dwindle as people buy their eggs and go home, other arbitragers may arrive with their own supplies of underpriced eggs, or the farmers selling eggs for $2 USD might simply cut their prices. In currency arbitrage, though, these risks theoretically don't exist because the transactions are simultaneous and the market has the capacity to absorb the quantities traded.

Currency transactions can take place in many different places simultaneously and be linked together, and all be valid. If the conditions are met, then the arbitrager has earned a risk-free profit. However, even a split-second's difference among the transactions involved may result in a loss, not only because of changing market conditions but also because of the actions of other arbitragers. This is why the most current, sophisticated arbitrage software is necessary, together with the very fastest computers.