In economics, arbitrage refers to the practice in which one can take advantage of the price difference between two or more markets. It is a little different in trading. It is a tool that helps the retail traders take advantage of the market inefficiencies that may occur every now and then. Arbitrage basically means concurrently selling and buying the same type of securities, for example, currencies, to make a profit out of their market price differences. For example, X has invested in two currencies, USD and EUR. The value of EUR rises as compared to USD. X will now go low on EUR and purchase more of USD as he can get more of USD now. This is possible because of the temporary price difference between the two currencies and X was able to make a profit by selling EUR for USD.
When understanding arbitrage, it is essential to know what swaps are.
Interest Rate Swap Arbitrage represents the exchange of an equivalent amount of assets between two counterparties to achieve certain objectives where traders take advantage of imperfections in financial markets to improve their rate of return.
Swaps and Arbitrage
Swaps refer to the opportunity that a trader takes by buying and selling forex and making a profit from the difference in interest rates associated with the two currencies. It is the difference between the interest rates of both the countries ( of the forex pair) that decides if the trader will make a profit or lose. When the trader exchanges the currency that has a high rate of interest, with the currency that has a low rate of interest, he is on the positive side i.e., he makes a profit. However, if the trader is not efficient enough to understand the situation and does the opposite, he may incur losses.
But the above situation is possible only when the trader is able to trade in forex without paying swap rates. Swap rates are the difference between the interest rate of the currencies being traded, that the trader has to pay. This interest rate swap arbitrage can be exempted if the trader could find a broker who could help him open a swap-free trading account.
If we consider this case, a retail trader will end up with a swap paying account indebted with a net market loss and a swap-free account with a net profit. If the trader wishes to re-open any position, they are required to transfer money between the above-stated accounts and pay a transfer cost on the transactions. You can take advantage of this strategy when the currency pair is volatile.