With foreign exchange investments, the strategy known as arbitrage lets traders lock in gains by simultaneously purchasing and selling an identical security, commodity, or currency across two different markets. This move lets traders capitalize on the differing prices for the same asset in the two disparate regions on either side of the trade.
Key Takeaways
- Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market for a higher price.
- The temporary price difference of the same asset between the two markets lets traders lock in profits.
- Traders frequently attempt to exploit the arbitrage opportunity by buying a stock on a foreign exchange where the share price hasn't yet been adjusted for the fluctuating exchange rate.
- An arbitrage trade is considered to be a relatively low-risk exercise.
What Is Arbitrage?
Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share. The arbitrage strategy can be used in many markets, including those for trading stocks and those for currency trading.
In the stock market, traders exploit arbitrage opportunities by purchasing a stock on a foreign exchange where the equity's share price has not yet adjusted for the exchange rate, which is in a constant state of flux. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange. This difference positions the trader to harvest gains from this differential.
Although this may seem like a complicated transaction to a beginner, arbitrage trades are quite straightforward and are considered low-risk.
Example of Arbitrage
Consider the following arbitrage example:
TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). First, let's assume the stock trades for $63.50 CAD on the TSX and $47.00 USD on the NYSE. Next, assume the USD/CAD exchange rate is $1.37—meaning that one U.S. dollar equals $1.37 CAD. So, using our share prices from the two markets, the $47 USD share should equal $64.39 CAD on the TSX. But it does not; the current price on the Toronto exchange is less.
Under this set of circ*mstances, a trader can purchase TD shares on the TSX for $63.50 CAD and simultaneously sell the same security on the NYSE for $47.00 USD. Taking the exchange rate into consideration, the equivalent value of each share should be $64.39 CAD. Ultimately the trader yielded a profit of $0.89 per share ($64.39 – $63.50) for this transaction.
Beware of Transaction Costs
When contemplating arbitrage opportunities, you must consider transaction costs, because if they're too high, they will neutralize the gains from those trades. For instance, in the scenario mentioned above, if the trading fee per share exceeded $0.89, it would nullify any profits.
Price discrepancies across markets are generally minute in size, so arbitrage strategies are practical only for investors with substantial assets to invest in a single trade.
Is Arbitrage Legal?
Yes, arbitrage is legal in the U.S. Many investors like this type of trading because it provides liquidity and encourages market efficiency by identifying price discrepancies and fostering price convergence.
Can You Lose Money in Arbitrage?
You can lose money in arbitrage. Although pure arbitrage should be no-risk and the price differences are typically very small, there are still some limits to arbitrage. Traders still face execution risk, counterparty risk, and liquidity risk in trading.
What Makes Arbitrage Low-Risk?
Pure, "textbook" arbitrage is considered low- (or no-) risk because it doesn't involve additional capital; it's merely buying in one market and selling in another. And, since the price difference is so low, the amount risked is usually low, too. However, arbitrage in the real world usually entails large-volume trades as well as leveraged capital, timing variations, and other factors that increase risk.
The Bottom Line
If all markets were perfectly efficient, and foreign exchange ceased to exist, there would no longer be any arbitrage opportunities. But markets are seldom perfect, which gives arbitrage traders a wealth of opportunities to capitalize on pricing discrepancies.
