What are 3 Methods of Forex Arbitrage and How Do They Work?

The definition of the Forex arbitrage states that it is basically a very low-risk method, where traders exploit the pricing inefficiencies in the market, by buying and selling several currency pairs simultaneously. In Forex trading, there are essentially three ways to use the currency arbitrage strategy.
 
The First strategy, also called a triangular arbitrage, involves opening positions with 3 currency pairs. For example, a trader can open 3 positions with USD, EUR, and GBP:
What is Forex arbitrage
As we can see from the table above, an individual starts with buying 10,000 Euros for 11,000 USD. The second position involves selling the same amount of EUR for 8,800 Pounds. Finally, the trader opens a third trade, where he or she sells the same amount of British currency for $11,044. So an individual has earned $44 from this process which is called triangular arbitrage.
 
The second method lets traders exploit the interest rate differentials between different currencies. For example, an investor based in the US might decide to convert his or her US dollars to the higher-yielding currency and invest in that country. At the same time, in order to cover the exchange rate risk an individual might purchase a forward or options contract. This lets an investor lock in the exchange rate when the term of those investments expires and the amounts will be converted back into US dollars.
 
Finally, traders can make use of the statistical Forex arbitrage. This might sound complicated but this can be simpler than it seems. It essentially involves buying the underperforming or undervalued currencies against its overperforming or overvalued peers and consequently benefiting from the market corrections.
 

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Forex Arbitrage Explained

There are plenty of Forex strategies, however, traders always look for those methods where they can reduce their risks as much as possible, while still being able to earn decent payouts.
 
One approach which might satisfy the above mentioned two criteria is the triangular arbitration strategy. As the name itself suggests, it involves the use of three currency pairs. In order to explain this in more detail, and see how arbitrage trading works, let us return to the table above.
 
Basically, what happens here is that the entire process is completed in 4 stages:
 
  • An individual opens a long EUR/USD position by buying €10,000 and selling $11,000.
 
  • The trader then opens a short EUR/GBP position, purchasing £8,800 in exchange for the sale of €10,000.
 
  • After that, the individual opens a short GBP/USD position by buying $11,044 and selling £8,800.
 
  • The trader closes all three positions and earns a $44 payout in the process.
 
As we can see from this example, the triangular Forex arbitrage strategy can be quite straightforward, however, there are some considerations.
 
Firstly, for simplification, there are round numbers used in this example. Also, 50 pip arbitrage opportunities were used for demonstrating purposes, and in real life trading, this is very rare indeed, especially when it comes to the major currency pairs.
 
Secondly, when those kinds of opportunities do appear, it is not only visible to one trader, but to thousands of market participants. Trades can also use the Forex arbitrage calculator, which can be much faster compared to making those calculations manually.
 
This is the reason why the triangular Forex arbitrage opportunities are usually very short-lived and the market is quick to correct those pricing inefficiencies. Therefore it is essential for a trader to act quickly on those possibilities before they disappear because of the inevitable adjustments.


Is Forex arbitrage possible with the interest rate differentials?

When discussing how to use an arbitrage strategy in Forex it might be helpful to point out that the above-mentioned method is not the only one and actually there are some other arbitration techniques a trader can use.
 
Covered Interest arbitrage is another possible option. This approach aims to exploit the interest rate differentials between the two currencies. For example, nowadays the Federal Funds rate is confined within 0 to 0.25% range. Consequently putting money in the Bank Certificates of deposit might not be the most attractive option for many people. Therefore investors are looking for other ways to earn a decent return on their savings.
 
One alternative can be the use of covered interest arbitrage. This essentially means, for example converting low-yielding USD funds to higher-yielding currencies.
 
This can be done in two ways. For example, an investor can sell his or her USD assets and deposit this amount to the Russian ruble savings account. Since the Bank of Russia still keeps interest rates above 5%, then it is possible to earn similar returns. The obvious problem here is the exchange rate risk. To tackle this issue, an investor can buy a forward contract and lock in the exchange rate, once the term expires and he or she converts the investment back into US dollars.
 
Alternatively, an individual can open a short USD/RUB position, earning up to 5% annually on the interest swaps. At the same time, a trader can purchase an option to protect the investment from a possible Ruble depreciation.
 
To see how this type of arbitrage trading in Forex can be explained, let us take a look at this Daily USD/RUB chart:
How Forex arbitrage works

So let us suppose that a group of traders has decided to use the covered interest arbitration method with this pair. So they have opened a $100,000 short position with USD/RUB at 65, while at the same time purchasing an option, which gives them the right to close this trade at 65.50.
 
If those market participants decide to close the position by the early January 2020, at 62, then traders would earn approximately $4,839 profit from this trade and $5,420 in interest swaps. So in total that would represent a nice $10,259 payout.
 
On the other hand, if they have waited longer and faced a ruble depreciation that took place, traders would exercise the option and close the trade at 65.50, instead of 74. As a result, those market participants would have lost $763 because of the exchange rate, however, would have gained $7,080 on the interest swaps. This would represent quite a decent $6,317 payout.
 
As we can see from this example, traders can benefit from both scenarios. So this is the essence of Forex covered interest arbitration strategy.


How to use Statistical Forex arbitrage strategies?

One can argue that no Forex arbitrage guide will be complete without mentioning the Statistical Forex arbitration method. This approach is quite different from the other ones mentioned above. Basically this strategy aims to identify underperforming currencies and buy them against the overperforming currencies. The reasoning behind this method is as follows: unlike in the Stock market, which over the long term has a tendency to rise significantly, the Forex Major pairs mostly move in cycles.
 
For example, if we take a look at the historical charts, we can see that in some years USD was the strongest currency, while in some other periods the Euro or the Japanese yen were the best performers in the market. So in Forex, there is no one single currency that constantly rises, instead, all of them go through the bullish and bearish cycles to some extent.
 
Here it might be helpful to mention that when it comes to using a statistical arbitration strategy, there is no single universal method of measuring currency valuations. In fact, there are dozens of indicators, some of them using complex formulas or patterns to come up with some results.
 
Luckily traders do not have to go through those complicated measurements. Instead, they can use the Purchasing Power Parity. The basic idea behind this theory is that over the long term, currency exchange rates converge towards the PPP level, which is a rate at which the prices of goods and services will be equalized between the two countries.
 
The Purchasing Power Parity is measured by the Organisation for Economic Cooperation and Development, as well as by the British financial magazine the ‘Economist’. The updated version of PPP data is available from the websites of those two organizations.
 
So how can this method work in practice? According to the Economist’s Big Mac Index (BMI), the Japanese yen is one of the most undervalued major currencies. In fact, by the time of publishing the latest report it was 24% undervalued against the Pound and 29% undervalued against the Euro.
 
Then what would have happened if a trader decided to buy the Japanese yen against those overvalued currencies? To answer this question, let us take a look at this daily EUR/JPY chart:
How to use an arbitrage strategy in Forex

As can be seen from the above, during recent months the EUR/JPY pair did fluctuate significantly, but at the same time, the Euro is clearly in the long term downtrend against the Yen.
 
So how can this be explained? Well, according to the Economist, the Purchasing Power Parity for those two currencies is at 106 mark, yet as we can see at the beginning of this chart the pair traded well above 128 level.
 
According to the PPP theory, this disparity made the Japanese goods much cheaper and consequently more attractive compared to their European counterparts. Therefore, businesses and individuals recognized this opportunity to purchase raw materials and other goods at lower prices. However, in order to access those, investors and businesses had to convert their currencies to JPY. As a result, the demand for the Japanese currency increased and it started appreciating against the Euro.
 
Also, most traders using this strategy do not usually confine their trades to one currency pair, instead, they create the basket of undervalued currencies and open several positions accordingly.
 
Finally, it might be useful to point out that currencies do not always converge towards PPP levels in a short time frame. Sometimes it might take months or even longer for the market to adjust, therefore this arbitrage strategy might be more effective for long term trading.
 
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Basics of Forex Arbitrage - Key Takeaways

  • The Forex arbitrage definition is simple: it is a very low-risk strategy, which involves buying and selling currencies with the aim to exploit the pricing inefficiencies in the market. There are essentially 3 types of Forex arbitrage that traders can use.
 Arbitrage trading in Forex explained
  • The opportunities for the Forex triangular arbitrage are usually short-lived, with so many participants, the market is quick to respond and address those inefficiencies.
 
  • There is no one universally accepted rule for identifying currencies for the use of statistical arbitrage. There are several technical and even fundamental indicators traders can use for this purpose. Also, it might be helpful to mention that this type of arbitrage might be more suited for long term trading style, rather than for trades with a shorter time frame.

FAQ: Guide to Forex Arbitrage

How does Forex arbitrage work with multi-currency accounts?

Several American banks now offer their clients an opportunity to open multi-currency accounts. The main advantage of this banking product is that it lets people keep their balances in several major currencies. In fact, brokerage companies also started to offer this option to their customers.
 
Consequently, it must be mentioned that the use of those arbitrage Forex strategies is not strictly confined to Forex trading accounts. Indeed investors can open the certificates of deposit in higher-yielding currencies and protect themselves against the exchange rate risk by purchasing a forward contract, as discussed above.
 
Also, clients might choose to hold balances in undervalued individual currencies and benefit from their potential appreciation. Some commentators even call this a ‘simplified version of Forex trading’.


Is the arbitrage strategy in Forex trading completely risk-free?

Some sources do describe Forex arbitrage strategies as risk-free, however, this might not be the most accurate assessment for some traders. The use of those techniques does not completely eliminate the risk from the equation.
 
In the case of a triangular arbitrage strategy, there is a possibility that a trader can not manage to open 3 positions simultaneously before the market notices the opportunity and it disappears. Also if an individual leaves those trades open overnight, the rollover charges can easily wipe out all of the gains, made by this method.
 
With the covered interest arbitrage in Forex, there is a risk that the central bank who controls the high yielding currency, might decide to cut rates and therefore reduce the potential returns.
 
Finally, in the case of statistical Forex arbitration, there is a possibility that the underperforming currencies might take longer to appreciate than it was originally expected.
 
So each method does have its own specific risk, although one can argue that it is still much lower compared to other Forex strategies.


What are the hot money flows and how is this connected to the arbitrage strategies?

The hot money flows are mostly short term investments that are attracted by the high-interest rates in a given country. Savers and investors who are residing in a place where the local returns on investments are low might choose to invest in other countries where the interest rates on certificates of deposit or government bonds might be higher.
This is essentially the same method, as described in the second arbitration strategy above.


What are some of the mistakes traders can make when using arbitrage strategies?

One mistake with the FX arbitrage strategy can be not to execute trades in a timely manner. If there is a clear opportunity for a triangular arbitrage method with a combination of three currency pairs, the trader must act quickly, otherwise, the potential for instant earnings might disappear before all those positions are in place.
 
Also, some of the statistical arbitration techniques are mostly designed for long term trades, therefore using them for day trading purposes can be a serious mistake and lead to serious losses.
 
Finally, when it comes to the interest arbitration strategy, traders must not forget to protect themselves from the exchange rate risk by purchasing the appropriate currency forward or options contract.


What are some of the most undervalued major currencies according to the Purchasing Power Parity measures?

According to the latest Purchasing Power Parity data, published by Economist in January 2020, the Chinese Yuan and the Japanese Yen are the most undervalued major currencies, with each of them trading more than 35% below the PPP level against the dollar.
 
USD is also more than 20% overvalued against the New Zealand Dollar and Australian Dollar. The undervaluations against the US dollar are within 5 to 20 percent range in the case of the Euro and the Canadian dollar.
 
However, the most overvalued major currency is the Swiss Franc, which is more than 15% above its PPP level against the USD.
 

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