Arbitrage in Foreign Exchange Derivative Markets - dummies

Arbitrage in Foreign Exchange Derivative Markets

By Ayse Evrensel

Arbitrage implies taking advantage of price differences in the same or similar financial instruments. The golden rule of making money is also embedded in arbitrage: You want to buy low and sell high. Arbitrage opportunities may arise between different derivative markets. The next example implies that you observe a different exchange rate on forward and futures contracts and want to take advantage of it.

Suppose that September futures for the Mexican peso imply $0.08, while a forward contract implies $0.084. Clearly, the futures and forward contracts show a difference in the dollar price of the Mexican peso. You can buy pesos at the lower price of $0.08 on a futures contract and sell them at the higher price of $0.084 on a forward contract.

Now, suppose you want to buy and then sell MXP10,000,000. You pay $800,000 to buy MXP10,000,000 on a futures contract ($0.08 x MXP10,000,000) and sell them for $840,000 on a forward contract ($0.084 x MXP10,000,000). You make a profit of $40,000 by engaging in arbitrage ($840,000 – $800,000).

If something sounds too good to be true, it usually is. In the information age and today’s well-connected financial markets, arbitrage opportunities don’t appear around every corner. Additionally, when they become available, market participants recognize them and engage in arbitrage, which makes the arbitrage opportunity disappear.

Here is why. As you buy pesos on the futures contract, the dollar price of pesos increases on these contracts. As you sell pesos on a forward contract, the dollar price of pesos declines in these contracts. The adjustment continues until the dollar–Mexican peso exchange rate is the same on futures and forward contracts — in other words, until no arbitrage opportunity exists.

In fact, futures and forward prices of the same currency for similar maturity are very close.