What is 'Arbitrage'?

'Arbitrage' refers to the practice of taking advantage of inconsistent pricing to lock in risk-free profits. If two banks are quoting rates where one bank's rate is higher than the other bank's offer rate, then an arbitrage opportunity exists.

Let's look at the following example:

Bank A quotes USD 1 = JPY 120.10 (bid) and 120.15 (offer)
Bank B quotes USD 1 = JPY 120.17 (bid) and 120.20 (offer)

As Bank B's bif rate 120.17 is higher than Bank A's offer rate 120.15, it is possible to buy USD from Bank A at 120.15, and to sell them to Bank B at 120.17 for a profit of two points, without creating a net exchange position.

Once they realise that this has arisen, one or both banks will quickly trend their rates so that the arbitrage opportunity disappears.

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