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.

For more information about the Forex market, contact one of our highly trained Forex specialists today!

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Market-Making

'Market-making' refers to the practice of quoting bid and offer rates to 'make a market'.

A benefit of market-making is that the price-making bank obtains more market information. Being aware of the transactions which are taking place in the market is important if the bank follows a strategy of taking positions.

It is not always desirable for banks to deal at their own prices. If rates are moving quickly in one direction because of a bias in the market, banks will be better off if they square their positions by dealing at market rates.

For example, if a bank is long USD 2,000,000 at JPY 108.10 and a very large trade deficit is announced, all market participants may expect rates to fall. Banks will tend to lower their quotes and possibly widen them as uncertainty grows. As there will be many keen sellers and possibly no keen buyers, it would be folly for a bank to wait in the vain hope of being able to sell at its offer rate. The prudent course would be to square off its position by dealing at another banks bid rate, and to trend its rates down accordingly. This will probably result in the bank taking a loss, but it is better to take a small loss now than to be caught and incur a much larger loss later.

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