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International arbitrage is buying and selling securities in the same quantity in two different markets simultaneously. It works on the concept of price differential and investors can benefit from the price differences between two markets.
In this article, we will look at what international arbitrage is, its types and its benefits.
What is international arbitrage?
International arbitrage refers to the process of buying and selling foreign securities simultaneously to benefit from imperfect pricing across international markets. An arbitrager works by buying securities at a low price from one market and then selling them at a higher price in a different market.
If the two markets exist within the same country, it is simply known as arbitrage. However, if the two markets are in different countries, it is known as international arbitrage.
International arbitrage is a rare opportunity as the prices in different markets are updated as soon as the price difference is spotted. As a result, the arbitragers can benefit from this transaction only till the time the difference does not get noticed.
International Depository Receipts (IDR), stocks and currencies are the most commonly traded securities in international arbitrage.
Let us consider an international arbitrage example to get a better understanding of the concept. Let’s assume that a stock is being traded both on the National Stock Exchange and the New York Stock Exchange.
The price of the security is INR 500 on NSE but comes to INR 525 on the NYSE after USD to INR conversion. In this case, individuals can buy the security from NSE at INR 500 and sell it on NYSE at INR 525 and gain a profit of INR 25 on each share.
Types of international arbitrage
With an understanding of what international arbitrage means, let us now understand the different types of international arbitrage. They can be classified into three types including:
- Covered interest arbitrage
In cases when a trader makes use of a forward contract to hedge against the risk of exchange rate while also trading in higher-yielding currency, this process is known as covered interest arbitrage.
The word covers here signifies the hedging against the fluctuation in exchange rate and interest arbitrage implies making profits from the interest rate differential.
- Two point arbitrage
It is a relatively simple technique that involves a trader buying a security in one market and selling it at a higher price in a different market. Factors such as currency exchange rates and lag in setting up prices can cause this difference.
The arbitrage is only successful when the transaction cost is less than the gain possible.
- Triangular arbitrage
Álso referred to as a three-point arbitrage, this type involves the trade of three currencies instead of two. This situation arises due to the mismatch in the exchange rates of varied currencies.
In this type, the trader sells currency A to buy currency B and then currency B to buy currency C. Finally, the trader sells currency C to buy currency A again.
Benefits of international arbitrage
International arbitrage can be a complex practice to follow, but it comes with a range of benefits. These include:
- Increased profit opportunities
The arbitrage function helps businesses increase their profit opportunities by benefiting from the price differential of one security in different countries. Additionally, they can gain further benefits due to different currency rates.
- Diversification
International arbitrage presents an opportunity for individuals to benefit from diversification. With the investments spread in different countries with different currencies, they are no longer exposed to the risks of a single market. It helps protect investors and traders from market volatility and minimises their risks.
- Efficient market allocation
Another benefit of international arbitrage is efficient market allocation. With the process of international arbitrage, traders help bring forth the discrepancies in the pricing across markets and ensure their resources are put to the best use. It enhances economic inefficiencies and economic growth.
- Access to unique opportunities
An opportunity to invest in the international market helps gain exposure to securities in the international market that might not be available in the domestic market. This provides wider exposure to all investors and traders.
- Hedging against risk
Lastly, international arbitrage serves as a hedging strategy that protects traders against risks. If an investor holds securities in one currency then they can use international arbitrage to hedge against the currency risks while also benefitting from price differential.
This range of benefits makes international arbitrage a viable opportunity for investors and traders to benefit from transactions quickly. However, keep in mind to account for the transaction fees while considering this opportunity.
Conclusion
International arbitrage is a valuable strategy that helps investors benefit from the price differential in different countries. Some of the key benefits of international arbitrage include hedging against risks, access to unique opportunities, increased profit opportunities, etc.
Even though available for a limited time, arbitrage international strategy is a valuable tool to avail of gains. However, keep in mind to calculate the transaction cost when going ahead with the trade. To learn more, read blogs on StockGro.
FAQs
International arbitrage refers to buying securities from one market and selling them simultaneously in another foreign market to gain from the price differential.
International tax arbitrage refers to the process of benefitting from the differences in the way capital gains, incomes and transactions are taxed in different countries.
The benefits of international arbitrage include increased profit opportunities, hedging against risks, access to unique opportunities, efficient market allocation and diversification.
Yes, risks such as unexpected market conditions, price fluctuations and volatility make international arbitrage risky. Additionally, transaction costs can also negatively impact the trade if they exceed the profit earned.
The different types of international arbitrage include covered interest arbitrage, two-point arbitrage and triangular arbitrage.
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