Today, the value of the stock market in the Russian economy is growing rapidly, especially for entrepreneurs at various levels. But the basis of a large number of operations in the stock market is nothing but arbitration. Arbitration operations are of great economic importance for the entire financial market. Since they are based on capitalizing on differences that exist between markets or on the same market between contract terms, the intervention of arbitrageurs allows for the interconnection of rates and market regulation. In contrast to speculation and hedging, arbitrage facilitates short-term equalization of rates in various markets and smoothes out sharp market fluctuations, increasing market stability. So, this article discusses in detail currency arbitrage and its typesas well as relevant principles. How should this concept be understood? What is its significance in the economy of the Russian Federation today? What is the reason for this?
Currency arbitrage: concept and essence
Today, the basis of a large number of operations in the securities market is arbitration. It represents the extraction of income through the re-sale of securities subject to more favorable prices. However, it should be remembered that arbitration involves not only the performance of certain operations in the stock market. In the broad sense of the concept, it can be interpreted as the purchase of a particular product under the condition of an extremely low price and its sale in another market, respectively, at a high price simultaneously. Obviously, the result of the above activities is nothing but profit.
Arbitration operations are divided into two main types: stock and currency arbitrage. This article mainly addresses the latter (by the way, its other name is interest arbitration).
Under currency arbitrage in cash markets should be understood the movement of these resources directly from the currency of one country to the currency of another. It is important to supplement that currency arbitration involves its main goal is to improve the conditions in the process of borrowing or lending. In fact, the type of arbitration operation under consideration, one way or another, consists in determining the country or currency with the extremely favorable interest rate on the loan. It is interesting to know that in the event of currency arbitrage, financial instruments are usually government bonds or bank deposits. By the way, today we know such a thing as currency arbitrage in the cash market uncovered type. Such transfers take place when the transfer of funds from the currency of one country to the currency of another implies, one way or another, the existence of a corresponding risk.
Arbitration risk
As it turned out, uncovered currency arbitration involves the presence of some risk. So, if a certain speculation with respect to the currency is nevertheless justified, then the risk that is directly related to the combination of an open position in the currency with interest arbitration gives the relevant entity the opportunity to receive additional profits. Naturally, the latter significantly increases the gain received due to the interest arbitration itself.
It is important to note that in case of parity violation there is an arbitration situation. So, foreign exchange contacts can easily arbitrate directly against bank interest rates with respect to deposits and spot rates.It is clear that the potential profit from this type of operation almost ignores the movement of interest rates, but even feels the slightest fluctuations in exchange rates.
Currency Arbitration: Principles
As it turned out, currency arbitrage, in accordance with its historical value, should be understood as transactions with currency combining the purchase or sale of it subject to a subsequent counter-transaction. The main goal in this case is to make a profit directly due to exchange rate fluctuations or currency differences over a certain period of time. When applying the law of a single price in relation to financial markets, we can formulate currency arbitrage in the cash market as follows: in all countries of the world, the exchange rate of a particular currency is approximately the same. A deviation from the norm of exchange rates in diverse markets is determined by nothing more than the amount of expenses in relation to different operations. The latter, as a rule, are associated with the transfer of these currencies from one market to another.
How does it happen in practice currency arbitrage? Exercise technique suggests that, for example, the US dollar rate in Tokyo, one way or another, but will be different from the US dollar rate in New York directly by the amount of expenses for the relevant operations. The latter, as already noted, are primarily associated with the transfer of this currency from the United States of America to Japan. If there are cases when the exchange rate is different from the other by a significant (compared to the implementation of exclusively operating expenses) value, then, one way or another, it becomes possible to implement speculative operations, playing on the difference in this rate. So, currency arbitration is just this kind of action.
Features of arbitration operations
It is important to note that arbitration operations in percentage terms are completely small. That is why foreign exchange arbitration profitable only when carrying out large-scale transactions. The implementation of the latter, as a rule, is carried out through the largest institutions directly related to financial activities.
The fundamental principle of arbitration is the acquisition of a financial asset subject to a lower cost and, accordingly, its sale under a high cost condition. It should be noted that currency arbitrage It is carried out only subject to the following factor: ensuring free overflow of capital directly between different market segments. In other words, this is an absolute absence of currency restrictions and limits in terms of the implementation of certain types of activities for various types of agents. In addition, this includes free convertibility, which is important in relation to the issue under consideration. The technique in accordance with which currency arbitrage, indicates the presence of some discrepancies in the quotes of financial instruments. This position relates to both space and time.
Classification of Currency Arbitration
To date, it is customary to distinguish the following types of currency arbitrage:
- Temporary currency arbitration. It is important to add that this type is classified into simple and complex arbitration. The second is often called indirect.
- Spatial Currency Arbitration.
In the case of simple currency arbitrage, the necessary actions are taken in respect of two currencies, subject to cash and forward transactions. In complex arbitrage, the relevant transactions are carried out with three or more currencies. Need to complement that complex currency arbitrage, one way or another, involves raising brokers on imaginary steps. At the same time, there is an exchange of purchased currency units for third, fourth, fifth, and so on.It is necessary to add that at the final stage of the above actions it is absolutely not necessary to return to the original currency.
Currency Arbitration complex type can be implemented when the cross-rate calculated directly between two different currencies, in some way differs from the quoted rate in fact in a particular market or in some of their banking institutions.
Types of arbitration and their features
As it turned out, today distinguish between temporary and spatial currency arbitrage. The latter, as a rule, is applied directly in order to make a profit precisely due to the difference in relation to rates in different currency markets. Temporary arbitration implies that exchange gains are formed due to changes in the course over a certain period of time. So, this type is closely related to the category of currency risk. It is important to add that interest arbitration is a type of monetary arbitration. In the case of the latter, profit appears directly due to the difference in exchange rates and interest rates.
It should be noted that in the process of developing the monetary and global system, varieties and forms of currency arbitration also changed. So, during the period of the “gold standard”, the practice of currency arbitration was widely known, which primarily depended on the exchange rate difference of bills, gold, currencies, as well as all possible credit-oriented means. However, a little later, the value of the gold arbitration was lost. Why so? The point is mainly that the “gold standard” has ceased, and the spatial one, despite everything, continued to be actively used, because due to the not very fast and reliable connection directly between the foreign exchange markets, the existing difference in relation to the dynamics of exchange rates remained .
The main differences
What else are the differences between temporary arbitration and spatial arbitration? Compared to the temporary type, in the case of spatial arbitration, a closed position is formed in terms of currencies. Why? The fact is that in different foreign exchange markets, both the acquisition and sale of the corresponding objects are simultaneously implemented. So, a large currency risk cannot logically arise.
Due to modern conditions for the development of information electronic tools, as well as due to the expansion of the number and volume of transactions with foreign currency, differences in exchange rates but in individual currency markets began to appear much less frequently. It is for this reason that spatial arbitration has completely lost its own meaning, which means that it has ceded its place to temporary arbitration.
Species depending on the purpose
In addition to the above classification, today there is a division of currency arbitration into types depending on the purpose of implementation:
- Speculative currency arbitrage.
- Conversion currency arbitrage.
In the case of the first of the foregoing currency arbitrage, the main goal is to profit (in other words, to obtain a certain amount of profit) directly from the difference between the exchange rates. The reason for this is none other than the fluctuation of the latter. It should be noted that in this case the source and final currency must coincide, that is, the transaction is carried out approximately according to the following scheme: EUR / USD; USD / EUR
In the case of the second of the presented types of currency arbitrage, the key goal pursued is the extremely profitable purchase of a certain currency, which is necessary directly for the subject of the relevant activity. In other words, conversion-type currency arbitrage is nothing but the use of competitive quotes from various banking institutions in one or some of the currency markets. It is important to add that the possibilities of this type of arbitration are much wider.Why so? The fact is that the exchange rate difference in this case is not so big compared to speculative arbitration, where it, as a rule, not only covers the marginal profit between the exchange rates of buyers and sellers, but also brings, in one way or another, a certain amount income.
Conversion operations
Today, conversion operations are referred to as such operations of acquisition-sale (conversion, exchange) of previously agreed currency amounts of one country directly to the currency of another country or the corresponding number of international currency units (on a specific date). In modern times, conversion operations are defined through the term “forex”. It is important to add that in relation to the global currency market conversion operations of an interbank nature prevail.
It should be noted that in modern times, exchange rates in various markets that sell the corresponding product, very rarely have some deviations by a value equal to or greater than the difference between buying and selling rates. This provision, of course, makes it possible to use exclusively currency conversion arbitrage in a practical aspect. In other words, banking institutions buy the currencies they need directly in those markets where their value is lower.
Thanks to innovative information tools, today you can effortlessly monitor absolutely all changes in relation to currency quotes in leading currency markets. Assuming certain currency arbitrage indicator also speaks of the existence of overhead costs directly related to communications. The important thing is that in this case they have significantly decreased. So, in conditions of a significantly increased minimum volume of transactions, these expenses are no longer felt as they were before.
Classification by implementation technique
In accordance with the implementation technique, today currency arbitration is classified into the following types:
- Interest rate currency arbitrage. This type indicates the aspiration of capital directly to those states where interest rates are significant in magnitude. It is important to note that interest arbitration is closely related to actions taken in the markets of other countries, where interest rates are much lower. In addition, this type in any case involves the placement of the equivalent of borrowed currencies in the national financial markets. In the latter, of course, interest rates are higher. It should be noted that at the same time, banking institutions are vested with the right to conclude an agreement on the implementation of a foreign currency loan for a specific period of time in order to protect themselves from risks of a currency nature.
- Equalizing currency arbitrage. This type indicates the use of price differentiation in order to obtain a certain amount of profit. This kind of currency arbitration is direct and indirect. In the first case, the use of exchange differences between the currency of debtors and creditors is appropriate. In the second, there is a participation of the third currency, acquired at an extremely small rate and sold later instead of payments.
- Differentiated currency arbitrage. This variety indicates the use of price differentiation in different currency markets. At the same time, there are no open positions and currency risk.
- The currency-interest type of arbitration is nothing more than a form of simple interest arbitration. It is mainly based on the application by banks of the difference in interest rates for those currency transactions that are carried out in accordance with different time frames.