What is International Arbitrage?

Every day, millions of traders trade in financial markets around the globe to make a profit on their investments.There are many ways you can make money on the financial markets. You can purchase a security at the dawn and then sell it by noon in an intraday trading. A person with a long-term investment plan can also buy and hold security for many months or years to increase his/her investment. Arbitrage is a form of trading that allows a security to be listed on multiple exchanges.

What's international arbitrage?

International arbitrage refers to the simultaneous purchase and sale of the same asset on two different markets. International arbitrage is based on the principle that there is a price differential due to market inefficiencies. To earn a riskless profit, a trader may buy a security at a lower market price and then sell it at a higher market price. This is called international arbitrage. It would be considered a simple arbitrage trade if both markets are located in the same country. However, international arbitrage requires that both markets be located in different countries. International arbitrage opportunities don't exist as soon as price differentials are detected. International arbitrage is not possible if there is no price equilibrium on the market. International arbitrage trades include the purchase and sale of International Depository Receipts, currencies and the same stock that is registered in two countries.

Example of International arbitrage

Let's try to understand international arbitrage. Let's say that shares of company XYZ were listed on both the National Stock Exchange (NSE) and the New York Stock Exchange. On the NSE, shares of XYZ trade at Rs 500. The shares trade at $10.5 per share on the NYSE. Let's assume that the US$/INR currency rate is Rs 50. This means that 1US$ equals Rs 50. The price of shares on NYSE will equal Rs 525 at the current exchange rate. An investor can buy shares of XYZ from NSE and then sell them on NYSE for a profit of Rs 25 each. In real life, however, the difference can be very small so it is important to make sure that the exchange rate remains favorable for a while. When considering international arbitrage, it is important to consider the transaction costs. Arbitrage can be costly if transaction costs are high.

Types of International arbitrage

International arbitrage can be divided into several categories. There are three main types of international arbitration: triangular arbitrage, two point arbitrage and covered interest arbitrage.

Covered Interest Arbitrage: A forward contract is used by a trader to hedge against exchange rate risk and invest in a higher yielding currency. This is called covered interest arbitrage. Covered interest arbitrage is when the term 'cover' refers to a hedge against fluctuations in exchange rates and the word 'interest arbitration' refers to taking advantage of a differential interest rate. Covered Interest Arbitrage involves complex trading strategies and sophisticated setups.

Two point arbitrage: This is a basic trading technique in which a trader purchases a security from one market and then sells it to a buyer in another market. The dominant economic theory states that the currency exchange rate should be the same everywhere. However, due to differences in time zones and lags in the exchange rate, there is a price difference. A trader can take advantage of this situation by buying the currency at a lower price and then selling it in a higher market. Only if the transaction cost is greater than the exchange rate, can you make a profit.

Triangular Arbitrage: The triangular or three-point arbitration is a more advanced version of two-point arbitrage. This involved three currencies, or securities, instead of just two. Triangular arbitrage is when the exchange rates of three currencies are not in line. A three-point international arbitrage involves a trader selling currency 'A' and buying currency 'B. He/she then sells currency "A" and purchases currency "C". The final leg of arbitrage is when he/she buys currency "A" and sells currency "C".

Conclusion

International arbitrage is risk-free trading, but it is difficult to spot. Modern digital trading has made it possible to use sophisticated computers to identify arbitrage opportunities. Although the price differential in international arbitration may seem low, significant gains can be made if there is sufficient volume.