“Wealth gained hastily will dwindle, but whoever gathers little by little will increase it.”
—Proverbs 13:11 Eastern Standard Version
Currency Arbitrage is the act of trading in currencies such that you—an arbitrageur—can profit from price differences for the same currency in different markets. Since the foreign exchange market is the largest of all financial markets and technology has allowed currency trading to become real-time or at least nearly real time, an arbitrageur might find it difficult to profit because the same technology that has eased trading has also caused a market efficiency that erases price differential. Still, all is not lost. For a currency arbitrageur to profit, he/she would simply have to invest the currency in another market.
An example will help to clarify how the process works. Suppose that €1 = $1.5 for simplicity sake. Additionally, the interest rate in France is 5%, while in the US it is 8%. Now let us assume that you, the arbitrageur, have €1,000,000 to invest. You can exchange your currency from €1,000,000 to $1,500,000 (assuming there is no transaction cost) and invest in the US money market at 8% for three months. By the end of third month, you would end up with $1,530,000 ($1,500,000 x 8% x 90/360). You can then buy Euro at $1 = €0.67 = €1,020,000.
Arbitrage provides you with $7,500 excess profit. Alternatively, if you had invested your €1,000,000 in France at 5%, you would have ended up with €1,012,500 for the same period.
The above example helps to simplify our understanding of the process of currency arbitrage, but there is something else worth noting: currency arbitrage can be defeated by both the purchasing power parity and interest rate parity. If every investor from France started changing their Euros to US Dollars, the Euro/Dollar exchange rate will rise, and the US Dollars will become more expensive. As a result, purchasing power parity will erase abnormal profit. In the same manner, when every Frenchman starts to invest their money in the US money market, there would be an influx of money and the interest rate would start to go down; therefore, interest rate parity will also defeat an arbitrageur’s motive to make abnormal profits.
To learn more about currency arbitrage, watch the brief video produced by Khan Academy, titled “Arbitrage Basics” (2:51 min).
How well do you know foreign currencies? Can you name the currency for each of the following countries?
European Union Japan
Israel South Africa
For the answers, turn to the Wikipedia webpage “List of Currencies.”