What Is Foreign Exchange Arbitrage?

Foreign exchange (Forex or FX) arbitrage is the process of capitalizing on the difference in currency exchange rates between two or more foreign exchange markets in order to make a profit. The transaction involves the simultaneous purchase and sale of the targeted currencies. This allows for a closed or no risk position to be taken, avoiding market exposure and exchange rate fluctuations. A person or organization engaging in foreign exchange arbitrage is termed an arbitrageur.

The technique of exchange arbitrage is made possible by the structure of the market itself. The FX market is the largest financial market in the world. It is also the most liquid, with trade in currency carried out continuously from 20:15 GMT Sunday through 22:00 GMT Friday each week. There is no central regulated exchange, and major independent exchange markets exist in several financial centers including London, New York, Paris, Zurich, Tokyo, Singapore, and Sydney. Arbitrageurs include international banks, institutional and private investors, governments, and speculators.

All currencies are subject to trade in foreign exchange markets, but the vast majority of trading is performed within seven currency pairs. The most frequently traded currency pairs are the Euro and the U.S. Dollar, the U.S. Dollar and Japanese Yen, the British Pound and the U.S. Dollar, as well as the U.S. Dollar and the Swiss Franc. Three pairs are associated with commodity trading; the Australian Dollar and the U.S. Dollar, the U.S. Dollar and the Canadian Dollar, and the New Zealand Dollar and the U.S. Dollar.

The potential to make a profit from exchange arbitrage exists when separate markets are offering different exchange rates between currencies. An arbitrageur might buy one currency in one market while simultaneously selling in another. The profit for the transaction is the revenue generated minus the cost.

In reality, transactions are typically rather complex, often involving multiple markets and currencies. The profit margin for each transaction is usually small; however, the simultaneous buying and selling of currencies makes trading considered to be virtually risk free. The window of opportunity to profit from any discrepancies in exchange rates is usually very short-lived, as these differences are quickly corrected in response to arbitrageur activity. When there are no exchange rate differences to exploit, the FX market is said to be an arbitrage-free market, or in a state of arbitrage equilibrium.