Forex arbitrage (part two)

Forex arbitrage strategies exploit the differences in currencies’ quotes, rather than variations in the exchange rates of the currencies in a currency pair. Algorithmic trading systems have shortened the timeframe for forex arbitrage trades. In the past, price differences could last up to several minutes; nowadays they last only milliseconds, before moving back towards the equilibrium price. Thanks to the technological change, arbitrage strategies have made forex markets much more efficient than before. However, markets’ volatility and price quote errors still provide arbitrage opportunities, while the lack of execution rapidity, due to slow trading systems, can limit them. This is why financial companies have developed complex and automated trading software, in order to detect price differences and to execute forex arbitrage and real-time management solutions to control the outcome.

Among forex arbitrage strategies, two of them are related to covered and uncovered interest rates. The former exploits the use of favorable interest rate differentials and allows a trader to invest in a higher-yielding currency, hedging the exchange risk through a forward currency contract. The latter involves exchanging a domestic currency which carries a lower interest rate to a foreign currency that offers a higher rate.

Another arbitrage strategy captures spot-future discrepancies and involves taking positions in the same currency both in the spot and futures markets. Buying currencies on the spot market and sell them in the futures market when there is a pricing discrepancy is observed is the aim of this strategy.

In order to perform forex arbitrage strategies traders often need to borrow money at low interest rates, which generally are available only at large financial institutions. This is why these strategies are usually performed only by brokerages. Spreads, and margin cost overhead are additional risk factors that a trader should take into account.

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