TradingKey - In March 2025, the Federal Reserve announced its decision to keep interest rates unchanged for the second consecutive time and hinted at the possibility of two 25-basis-point cuts by year-end. Concurrently, the President of the Bank of Japan indicated that if inflation continues to rise and push wages up further, gradual increases in the policy interest rate cannot be ruled out. These shifts in policy expectations have narrowed the interest rate differential between the U.S. and Japan. For investors, accurately predicting these policy directions and adjusting their positions accordingly could unlock potential profits during exchange rate fluctuations. Consequently, investors must learn to effectively harness arbitrage trading strategies to attain superior returns in the forex market.

Carry Trade Strategy

Carry trading is a prevalent form of forex arbitrage strategy aimed at profiting from interest rate differentials between currencies of different countries. Investors can borrow in low-yield currencies, such as the Swiss Franc (0.25% interest rate), and invest in high-yield currencies, like the New Zealand Dollar (3% interest rate), to capture profits from the interest rate spread. In this scenario, investors may achieve an annual return of approximately 2.75% from the differential.

However, caution is warranted regarding fluctuations in exchange rates. Should the exchange rate of the high-yield currency decline against the low-yield currency by more than the earned interest differential, investors risk incurring losses. For example, if the exchange rate of the New Zealand Dollar to the Swiss Franc decreases by 3% during the holding period, investors may still face overall losses despite benefiting from a 2.75% interest differential.

Cross-Market Arbitrage

Due to differences in trading times and market participants, the same currency pair may exhibit price discrepancies across different markets. Cross-market arbitrage entails profiting from these price inconsistencies. For instance, if the exchange rate for GBP/USD is 1.3100 in the New York market while it stands at 1.3105 in London simultaneously, investors can buy GBP in New York and sell it in London, earning a differential of 0.0005 dollars for each pound sold. This arbitrage strategy can yield significant profits, particularly when executed at scale.

However, cross-market arbitrage demands rapid access to market information and an efficient trade execution system. Market prices can shift instantaneously; therefore, once discrepancies are detected, trades must be executed without delay, or the opportunity may vanish.

Triangular Arbitrage

Triangular arbitrage involves profits gained from discrepancies in exchange rates among three currencies. For example, consider the EUR/USD and USD/JPY rates where EUR/USD is trading at 1.15 and USD/JPY at 110.00, suggesting a theoretical EUR/JPY rate of 126.50. If the actual market rate for EUR/JPY falls to 126.00, this creates an arbitrage opportunity.

An investor could start with 1 million euros, first converting it to 1.15 million USD (1 million × 1.15), then converting that to 12,650,000 JPY (1.15 million × 110.00), and finally converting back to approximately 1.0079 million euros (12,650,000 ÷ 126.00), netting a profit of 7,900 euros. However, this strategy demands high trading speed and calculation accuracy, as opportunities based on exchange rate discrepancies are often fleeting.

Exchange Rate Fluctuation Risk

A primary risk inherent in forex arbitrage trading arises from sharp fluctuations in exchange rates. For instance, in carry trading, even if investors consistently earn interest differentials, a sudden drop in the high-yield currency’s exchange rate could negate or surpass interest earnings. During moments like the 2008 financial crisis, investors engaged in yen carry trades experienced significant losses as market panic prompted them to liquidate high-risk assets in favor of the yen for safety, resulting in drastic declines in the AUD/JPY exchange rate and sizable losses for yen borrowers.

In both cross-market and triangular arbitrage, rapid exchange rate fluctuations can erode arbitrage opportunities before trades are executed, possibly forcing investors to close positions at unfavorable rates, leading to losses.

Interest Rate Policy Risk

Central banks adjust interest rates based on prevailing information and economic conditions. Should the central bank of a high-yield currency unexpectedly cut rates or the central bank of a low-yield currency raise rates, it significantly impacts the interest differential profits derived from carry trades.

Transaction Cost Risk

Investors must account for various transaction costs when engaging in arbitrage trading, including fees and spreads. As both cross-market and triangular arbitrage involve multiple currency exchanges and trades, transaction costs may accumulate significantly. If these fees become excessive, they can substantially diminish arbitrage profits. Frequent arbitrage trading calls for caution, as accumulated fees may further erode thin arbitrage margins.

Market Liquidity Risk

During major political events or economic crises, liquidity in the forex market can swiftly decline, reducing market participants' willingness to trade and widening bid-ask spreads. This scenario may hinder arbitrage trading from occurring at anticipated prices, and in extreme cases, traders might find themselves unable to close positions promptly.

Stable Interest Income and Potential Currency Appreciation

During periods of relative stability in market exchange rates, carry trading can deliver a stable interest income for investors. This consistent return is undoubtedly appealing for those seeking long-term, reliable gains. Additionally, by monitoring market dynamics, investors can also capitalize on appreciation opportunities in financing currencies, further enhancing capital growth and overarching portfolio returns.

Risk Diversification Across Currency Pairs

Arbitrage trading offers investors the ability to diversify their investments across multiple currency pairs, effectively minimizing overall risk. Compared to traditional forex trading strategies, arbitrage trading typically shows a lower correlation with fluctuations in other markets. This characteristic means that, when stock markets or other financial markets face weakness or volatility, forex arbitrage can continue to generate profit opportunities. By incorporating arbitrage trading into their strategies, investors not only mitigate the overall risk of their portfolios but also uncover stable revenue streams even in uncertain market conditions.