Currency Arbitrage

.diIf you are trading in any financial market, you probably heard the term "arbitrage". This term means buying an asset at one market and selling it on another market, where the price is higher. Usually, this price gap is closed very quickly, but people who find arbitrage opportunities can make some quick, safe, profit.

Arbitrage is also possible at forex, but the high liquidity of the forex market makes it almost impossible to take advantage of such opportunity. Here is an example of a forex arbitrage you can use if you find (in this example there is no spread, but remember most forex brokers have).

There are three fictional currencies: ABC, DEF, GHI (original, right?). Their exchange rates are the following:
ABC/DEF = 2
GHI/DEF = 5

From these two exchange rates you can determine the exchange rates of all three pairs. Since the rate is a ratio between currencies, you can treat is as a mathematic proportion. That means the exchange rate ABD/GHI is 2/5 = 0.4.

Now, let's say that the direct trading of ABC/GHI reached a rate of 0.3. In this case, you can profit from the opportunity you got: if you trade from ABC to DEF to GHI, the rate is 0.4. If you trade from ABC directly to GHI, the rate is 0.3. A smart trader would do this (this example assumes the trader has 3000 GHI):

Buy ABC/GHI at 0.3 - sell 3000 GHI and buy 10000 ABC
Sell ABC/DEF at 2 - sell 10000 ABC and buy 20000 DEF
Buy GHI/DEF at 5- sell 20000 DEF and get 4000 GHI

As you can see, with three simple, risk free, orders, you created 1000 GHI out of nothing. Fortunately, this even is really rare, so people are not able to abuse such situations.

Hope you learned something,
Nadav

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