Financial Investing: Arbitrage Opportunities
By ICN Staff Rickey Lee, International Financial Consultant
When investing in financial instruments, the most important factor investors analyze is their ability to earn a return on investment. Today’s investor has an array of instruments that are used to accomplish this goal such as: corporate stocks and bonds, money market accounts, and foreign currency swaps just to name a few. The complexity of investing can quickly become overwhelming which is why for these kind of transactions you may want to get an international financial management consultant involved. In spite of all the current strategies, one in particular is being overlooked, arbitrage.
Arbitrage is the processes of capitalizing on the discrepancy in currency spot rates to earn quick profits. There are three forms of arbitrage that can be used, either Locational, Triangular, and Covered Interest. Considering spot rates change every second depending on market forces, supply and demand, investors need access to computer trading terminals to execute arbitrage effectively. Any time you are going to make a large investment involving foreign currency you should consider using an international financial management consultant to handle the details and to keep you informed of any problems.
Locational Arbitrage is the first form of Arbitrage. In the case of International Investors, large profits can be earned. Locational Arbitrage is the process of capitalizing on bid-ask prices of one bank and selling currency to another bank for a higher price. This method only works if bid-ask prices between banks do not overlap. For example, the bid price for a bank in which you will sell currency to a bank must be higher than the ask price in which you purchase the securities from another bank.
Locational Arbitrage will continue until factors erase the profit margins. The factors that erase profits are supply and demand. As demand for a currency increases at a bank, the bank will have no choice but increase their ask price since the currency is selling cheaply resulting in a shortage. On the other hand, the bank in which the investors sell the currency will accumulate a surplus and will decrease their bid prices until the ask prices and bid prices between the two banks are aligned. Remember, an international financial management consultant can assist you in completing these transactions.
Triangular is the second form of Arbitrage. Triangular Arbitrage involves capitalizing on the cross-exchange rates between two non-dollar denominations. As an investor, you can find daily exchange rates in the Wall Street Journal, Google finance, or other financial publications. The prices you will use when invested are the quoted bid-ask prices. In the case of Locational Arbitrage, if you hold the Japanese Yen, and wish to purchase the Euro dollar, you will locate the quoted exchange rate to execute the exchange. However, there are instances where the calculated rate is less than the quoted rate. For example, if you calculate a cross-exchange rate that is less than the quoted rate, engage in arbitrage, as profits are made.
Covered-Interest is the last form of Arbitrage. It involves taking advantage of interest rate differences between countries. This form of Arbitrage is popular amongst investors who look to invest in countries with high interest rates. It is also popular to use an international financial management consultant to handle these transactions. Due to exchange rate risk and the possible depreciation of foreign currencies, Covered Interest also involves purchasing Forward contracts to sell the currency back at a predetermined rate.
The forward hedge will insulate investors against currency exchange-rate fluctuations. As an investor, be wary of countries that possess high interest rates as inflation and interest are highly correlated. Interest Rates, according to the Fisher Effect, are composed of a real interest rate and inflation. Therefore, if a country has a high nominal interest rate, it may be due to a high inflation rate and a small real interest rate. Thus, as an investor, be cautious when investing and consider using an international financial management consultant when analyzing interest rate because they are very deceiving.
Concluding, as an investor, you will have tough decisions to make when attempting to earn profits. Arbitrage is one form of earning profits, which consists taking advantage of price variations. Living in a global economy means as an investor you need to take advantage of the expertise that an international financial management consultant and with his or her advice you can explore every avenue of investing. Considering trading never stops and due to logistic barriers, computerized systems is the most practical way to execute Arbitrage. Just be careful when investing and understand that a small window exists.
Locational Arbitrage Example:
|Currency||Bank X||Bank Y|
Arbitrage is possible because the bid and ask prices do not overlap
You have $1,000,000 to invest
- Purchase euro from bank y ($1,000,000/$1.42)= 1,420,000 Euro
- Sell euro to bank x(1,420,000 euro/$1,43)= $2,030,600
- Profit = $2,030,600-$1,000,000 = $1,030,600
Madura, Jeff. International Financial Management. 10th Edition. Cengage South-Western,. 2009