What is arbitrage trading?
Did you know that there is a trading system that can profit even when prices remain stable for quite a long time?
This kind of trading system does exist. This trading system is used by many large institutional currency managers and is one of the most popular ways to profit from trading.
It is called “carry trade”.
Arbitrage trading consists of two parts: borrowing or selling a financial instrument at a low interest rate, and then using the financial instrument to purchase a financial instrument with a higher interest rate.
While you are paying a low interest rate for the financial instrument you borrowed or sold, you are getting a higher interest rate gain on the financial instrument you purchased. Therefore, your profit comes from the spread between the two financial instruments.
For example, if you borrow $10,000 from a bank, the bank’s loan interest rate is 1% per year.
After you borrow $10,000, you buy a $10,000 bond, and the bond yield is 5% per year.
What is your profit?
Does anyone answer?
Yes, it is 4% per year. The difference between the interest rate of bank loans and the yield of bonds.
Now, you are probably thinking, “This is not so exciting compared to capturing the profits generated by market volatility.”
However, when you apply arbitrage transactions to the foreign exchange market, it is also exciting to see that your account funds increase every day due to the high leverage of foreign exchange transactions and the rules of daily interest rate payments.
You should know that with 20 times leverage and 3% spread, your annual rate of return is 60%.
In the next lesson, we will discuss how the carry trade works, when it works, and when it does not work.
How does arbitrage trading work in foreign exchange markets?
In the foreign exchange market, currencies are traded in pairs. For example, if you buy USD/CHF, you are actually buying USD currency and selling CHF currency at the same time.
As in the example in the previous lesson, you pay interest on the currency you sold, and you can earn interest on the currency you bought.
What makes arbitrage trading so special in the spot foreign exchange market? The answer is based on the position you hold, and interest payments occur every trading day. Technically, in the spot foreign exchange market, all positions will be closed at the last moment of the trading day. If you hold a position overnight, you just don’t see this happen.
Forex brokers will close your position before the end of the first trading day and open it again for you when the second trading day arrives. Then they will open your account based on the spread of the currency pairs you hold Pay or collect interest.
The leverage multiples that foreign exchange brokers can provide make arbitrage trading very popular in the spot foreign exchange market. The vast majority of foreign exchange transactions are margin transactions, which means that you only hold a small portion of the positions you trade, while your broker holds the rest. Some brokers require margins of only 1% to 2% of the total position held.
What does this mean?
Let’s take a look at the following example, this example will let you understand how much impact arbitrage trading will have on your account in foreign exchange margin trading.
Let’s take Zhang San, a foreign exchange novice, as an example. Suppose today is Zhang San’s birthday, and his grandparents gave him $10,000 as a birthday gift.
He did not intend to spend the money, but chose to deposit it with the bank.
Zhang San went to a local bank and opened a deposit account. The bank account manager told him, “Zhang San, the interest rate paid by the bank to you is 1% a year. Isn’t it wonderful?”
Zhang Sanxin thought: “1%, if you save 10,000 US dollars for one year, you can make 100 US dollars.”
“It’s not a bargain!”
Zhang Sanke is a shrewd person. He has been studying advanced foreign exchange foreign exchange courses. He knows a better way to invest this money.
Therefore, Zhang Sanwan declined the bank account manager: “Thank you, I think I should invest this money elsewhere.”
Zhang San has conducted simulated trading for up to one year for different trading systems, including arbitrage trading, so he knows the relevant situation of foreign exchange market transactions very well.
As a result, he opened a real account and deposited USD 10,000 in his account and put its plan into effect.
Zhang San found a currency pair with an annual spread of 5%, so he bought $100,000 for the currency pair. Because his broker’s margin requirement is only 1% of the transaction amount, Zhang San’s margin requirement is only $1,000. Now, Zhang San controls the currency pair totaling 100,000 US dollars, which will give him 5% interest per year.
If he does nothing, what will happen in a year?
There are three cases, let us explain separately:
- The exchange rate of the last three purchased currency pairs fell. If the exchange rate falls and the fund size of Zhang San’s account falls to the minimum margin amount required by the broker, Zhang San will be forced to close out, and finally, there will only be a deposit of 1,000 USD in Zhang San’s account;
- The exchange rate of a currency pair after one year is the same as that of a year ago. In this case, the value of the position held by Zhang San remained unchanged, but he received 5% interest from the position of $100,000. This means that for a single interest, Zhang San received $5,000. Compared to an account of 10,000 USD, this is a 50% gain;
- The currency pair appreciates. In this case, Zhang San will not only receive interest of at least 5,000 US dollars, he will also receive the benefits of currency appreciation. This will be his best birthday gift to himself next year!
With a leverage ratio of 100:1, Zhang San may receive a 50% return from his initial $10,000.
The following is the arbitrage transaction of AUD/USD in September 2010, when the spread between the two currencies was 4.40%:
If you buy AUD/JPY and hold the currency in the next year, you will receive 4.40% interest. Of course, if you sell AUD/USD, the opposite is true:
If you sell AUD/JPY and hold the short position in the next year, you will get a return of -4.40%.
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