"forex Arbitrage: Exploiting Price Differences For Profit In The Australian Market"

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Arbitrage in trading is the act of exploiting price differences or inefficiencies in financial markets, such as forex, commodities and stocks, with the aim of making a profit.

"forex Arbitrage: Exploiting Price Differences For Profit In The Australian Market"

Arbitrage is a useful process for traders because the possibility of profiting from incorrect pricing can help bring the asset price and the overall market back to equilibrium. It is a short-term trading strategy that can provide you with low-risk investments; however, as with all strategies, there are always some risks to consider.

What Is Arbitrage?

Arbitrage involves profiting from the difference in price between identical or related financial instruments, although this usually does not involve large percentage profits. The greater the market inefficiency pricing error, the greater the profit and the faster traders will jump into action to exploit it. This will reduce profit potential and bring the asset in line with other prices or market information.

An arbitrage opportunity often becomes apparent through asset comparison. If two currency pairs frequently move the same way but then start to diverge, this can introduce arbitrage in forex trading, under the assumption that the two pairs will eventually start to move together again. If two very similar assets are priced differently without justification, this could also represent an arbitrage opportunity.

This means that large inefficiencies or incorrect pricing won't last long, but small inefficiencies can last a long time as there is less incentive to capitalize on them.

Arbitrage pricing theory assumes that asset returns can be predicted based on their expected return, as well as accounting for macroeconomic factors that affect asset price. In trading, if this is true, an inefficiency can be identified and a trader can potentially profit from the difference between the “incorrect” price and the theoretical fair price.

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Arbitrage is often referred to as “riskless profit”, although in reality very few trades are risk free. Therefore, an arbitrage method can provide a win-win trading advantage, but if the arbitrage is based on assumptions and those assumptions are wrong, the trade can result in a loss. Arbitrage pricing theory is built on assumptions, which include the expected return on the asset, that interest rates will not change, and that we can identify all the variables that affect the asset's price. This is not feasible with a high degree of accuracy, but it can still alert the trader to a potential opportunity.

Arbitrage price theory tries to isolate where there is potential profit, also assuming that price will return to its historical trends. Mispriced things tend to revert to more realistic prices over time. So whether the theory is used or not, the concept is important for capitalizing on these types of trading opportunities.

Arbitrage works by taking advantage of financial markets and the fundamental factors that determine a security's price, such as supply and demand. This is done in several ways. There is statistical arbitrage, which is equivalent to mean reversion, as well as triangular arbitrage for currency markets. Some narrower strategies for arbitrage trading include risk arbitrage, fixed income arbitrage and covered interest arbitrage, all of which will be discussed below. Arbitrage strategies are similar to high frequency trading strategies, which are often used by institutional investors.

In all cases, a trader uses evidence and research to uncover a profit potential due to mispricing one or several assets.

What Is Statistical Arbitrage And Pair Trading?

Statistical arbitrage is the process of analyzing statistics of how assets typically perform and then looking at deviations. A high positive correlation between assets is a commonly used statistic, which is often found in another short-term trading strategy, pairs trading.

Using the stock market as an example, if Ford and General Motors prices usually move together but then suddenly move away from each other, this could be a temporarily exploitable opportunity. If they normally move together, there's reason to believe they will again in the future. This is based on a mean reversion model.

Using statistical arbitrage, a trader can sell the rising stock and buy the falling stock. They must be moving in opposite directions, otherwise they are still correlated. This way, the trader is not betting on the general direction of both stocks, but rather on profits if prices converge again.

Popular commodity products West Texas Crude and Brent Crude typically move together as well. They are priced differently, so if the typical spread between them narrows or widens, this could present a statistical arbitrage opportunity. This is demonstrated in the graphic below.

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Triangular arbitrage is often used for the forex market, when there is a price discrepancy between three related exchange rates. Triangular arbitrage involves three transactions: exchanging the initial for the first currency, exchanging the first currency for a second, and then converting the second back to the initial. If these transactions create an opportunity for profit, arbitrage will ensue.

The profit potential is usually small, although in times of high volatility or less traded currencies, the profit potential can be higher.

For example, if the EUR/USD bid is 1.0847 and the GBP/USD bid is 1.4808, this would imply a EUR/GBP bid rate of 0.7325. If the price is different, especially by more than a few pips, there is an opportunity to profit.

Retail arbitrage happens more outside of financial markets. Being able to buy a widget at Walmart for $5 and then sell it on Amazon or eBay for $6 is retail arbitrage, exploiting a mismatch in different markets.

Arbitrage Free Valuation

Let's put arbitrage in a real-world context. Imagine that all the houses on a street offer the same features and are priced the same, but one house is selling for much less. The house will not last long, as perhaps an owner will buy it, removing the poorly valued asset. However, someone may buy the property at the lowest price to resell it at the same price as other homes on the market in an attempt to make a net profit. This is known as retail arbitrage and can be done in a variety of ways and in a variety of markets.

Risk arbitrage is a speculative and event-driven trading strategy, also known as merger arbitrage. He tries to make a profit by going long on stocks that are targets of mergers and acquisitions.

A common example is when a company buys another listed on the stock exchange. Let's say Company A agrees to buy Company B for $10 a share. Typically, until the deal closes, the stock will trade at $9.75 on the stock exchange, not $10. It will not trade at $10 as there is a chance that the trade will not close.

The $0.25 represents a risk arbitrage opportunity. A trader could buy the stock for $9.75 knowing that if the trade closes, he will earn $0.25 per share purchased. This is the expected return risk premium, or the compensation for taking the risk.

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The risk is that the deal does not go through, in which case Company B's share price drops to where it was before the takeover announcement. Part of the risk can be offset by hiring a hedge. A hedging strategy might be to sell short the acquiring company (Company A) or buy a put option on Company B, assuming the premium does not outweigh the full potential gain.

Fixed income arbitrage is a strategy that can be used by traders in fixed income securities, such as stock and bond trading, with the aim of profiting from the difference in interest rates. Institutional traders can also employ this method on more complex interest rate products.

As an example, let's say two cities offer municipal bonds. Cities have very similar economies, debt loads, incomes, expenses and unemployment rates. One bond has a 3% yield, while the other has a 2.85% yield. A trader believes the two bonds should yield the same. So they sell the 3% bond and buy the 2.85% yield bond. If they are correct and the bond yields eventually line up, either going up, down or meeting in the middle, the trader will profit from the 0.15%.

The same concept can be applied to companies that issue bonds. If the companies are similar but the bonds offer different interest rates, there may be an arbitrage opportunity. A trader can short the “overpriced” yield and buy the “undervalued” financial asset.

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The risk is that the yields do not converge or the spread gets even wider. In the latter case, the trader will start to lose money.

Covered interest arbitrage exploits differences in foreign currency interest rates across countries. This is done through forward or futures contracts in order to reduce exchange rate risk.

The forward market accounts for interest rate differences between currencies. If the forward market does not accurately factor the

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