Foreign exchange futures arbitrage involves simultaneously buying or selling a particular foreign exchange futures contract while also buying or selling a related foreign exchange futures contract to create an offsetting position, thereby profiting from the price difference between the two related contracts.Depending on the correlation between the two contracts being traded, foreign exchange futures arbitrage can be further classified into inter-market arbitrage, inter-expiration arbitrage, and cross-currency arbitrage.
I. Inter-market Arbitrage
Inter-market arbitrage occurs when an investor anticipates that a particular currency will move differently across various markets. By taking advantage of price discrepancies, the investor can buy a foreign exchange contract in one market and sell a futures contract in another, thereby profiting by “buying low and selling high.”
But how do you “buy low and sell high,” and how do you determine the direction of the trade? The general approach is as follows: When a particular currency pair is trending upward in both markets, buy the one with the stronger upward trend and sell the one with the weaker upward trend; when a particular currency pair is trending downward in both markets, sell the one with the stronger downward trend and buy the one with the weaker downward trend.
For example, a trader engages in cross-market arbitrage trading of euro foreign exchange futures contracts on the European money market and the Chicago futures market, with each contract unit being 125,000 euros.In early June, the trader bought 80 euro futures contracts on the European money market at a rate of 1 euro = 1.0628 U.S. dollars and sold 80 euro futures contracts on the Chicago futures market at a rate of 1 euro = 1.0828 U.S. dollars.In early September, the trader closed out the positions in both markets at an exchange rate of 1 euro = 1.1028 U.S. dollars. The specific transactions are shown in the table below.
As shown in the table above, the trader made a profit of $400,000 in the European money market but incurred a loss of $200,000 in the Chicago futures market. However, because the trader engaged in inter-contract arbitrage—using the larger profit to offset the smaller loss—the net profit was $200,000.
2. Calendar Arbitrage
Calendar spread arbitrage refers to buying and selling foreign exchange futures contracts of the same currency but with different delivery terms in a market, that is, buying and selling near-month or far-month contracts. Because there are price differences between futures contracts in different months, arbitrage can be done by “buying low and buying high.”
The general strategy is as follows: If you predict that both contracts will trend upward in the future, buy the one with the stronger upward trend and sell the one with the weaker upward trend; if you predict that both contracts will trend downward in the future, sell the one with the stronger downward trend and buy the one with the weaker downward trend.
For example, in early March, on the Chicago futures market, the exchange rate for June-delivery euro futures was 1 euro = 1.3652 U.S. dollars, while the exchange rate for September-delivery euro futures was 1 euro = 1.3680 U.S. dollars.The trader predicted that euro futures prices would rise in the future, and that the June contract would rise more than the September contract, so the trader engaged in a spread trade. The trader bought 8 June euro contracts while simultaneously selling 8 September euro contracts.Two months later, the exchange rate for the June contract is 1 euro = 1.3752 U.S. dollars, and the exchange rate for the September contract is 1 euro = 1.3702 U.S. dollars. The trader’s profit after closing the position is
(1.3752 – 1.3652) 1,250,008 + (1.3680 – 1.3702) × 1,250,008 = 7,800
Therefore, if a trader can accurately predict the general direction of the market, they can earn substantial profits through inter-month trading.
III. Cross-Currency Arbitrage
Cross-currency arbitrage involves buying and selling foreign exchange futures contracts in the same market but with the same delivery date, in order to profit from price differences between different currencies. The trading strategy generally involves buying contracts for currencies expected to rise and selling contracts for currencies expected to fall.
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