When does arbitrage trading work?

When traders feel the existence of risk and are confident enough to buy high-yield currencies and sell low-yield currencies, the implementation of the carry trade strategy works best.
It’s as if the optimist saw half a glass of water in the glass. Although the current market environment is not ideal, he thinks things will get better. This also applies to arbitrage transactions. Current economic indicators may not be good, but the economic outlook needs to remain positive.

If a country’s economic prospects are very good, then the country’s central bank may have to take interest rate hikes to curb inflation risks.

This is conducive to carrying out arbitrage transactions, because the increase in interest rates means a greater spread.

On the other hand, if a country’s economic prospects are not so good, if traders believe that the country’s central bank may have to take interest rate cuts to boost the country’s economy, then no one will choose to buy the country’s currency for arbitrage Trading.

To put it simply, when investor risk aversion is low, the effect of carrying out arbitrage trading is the best. When risk aversion is high, investors are less likely to risk trading.

For example, the economic situation of a country is very severe, and the country is experiencing a recession. What do you think your neighbor next door will use his money for?

Your neighbor is likely to choose a safer investment with a lower return at that time rather than investing it in other places. As long as he can ensure the safety of his investment funds, he will not mind if the return rate is low.

This is necessary for him, because doing so can ensure that your neighbors avoid the losses caused by high risks when the economic situation deteriorates further. In foreign exchange jargon, we call your neighbors risk averse.

Large institutional investors, their ideas are not much different from your neighbors. When the economy is full of uncertainty, investors tend to invest their funds in safe-haven currencies, which have lower interest rates, such as the US dollar and the Japanese yen.

This is completely opposite to the operation of carry trade. The flow of capital to safe-haven currencies will result in the appreciation of lower-interest-rate currencies relative to higher-interest-rate currencies.

Standards and risks of arbitrage trading

Arbitrage trading standards

Finding the right currency pair to carry out arbitrage transactions is very easy. As long as the following two points are met, we can consider carrying out arbitrage transactions.

  1. Find currency pairs with high spreads;
  2. Find a currency pair that remains stable, or find a currency pair that is in an upward trend, and a currency with a high rate of return maintains its appreciation in the currency pair.

It’s simple, isn’t it? Let’s look at real examples of carry trades.

The picture above is the weekly chart of AUD/JPY. Until recently, the Bank of Japan maintained its “near-zero” interest rate policy.

The Australian dollar interest rate is the highest among major currencies (4.5% as of September 2010), and many traders choose to carry out AUD/JPY carry trades, which is also one of the reasons for the steady rise of AUD/USD.

From 2009 to early 2010, AUD/JPY rose from 55.50 to 88.00, which is an increase of 3,250 points.

If you combine this factor with the AUD and JPY spreads, the AUD/JPY has good long-term investment opportunities for some investors and traders who can discern the volatility of the currency market.

Of course, economic and political factors are changing the world every day. The spread factor between currencies may also change, which may prompt popular arbitrage transactions, such as yen arbitrage transactions are no longer favored.