The activity of buying an asset in one market and selling it in another market simultaneously is referred to as arbitrage. In currency markets if we buy and sell a particular currency simultaneously then we call it an Arbitrage. Arbitraging is also referred to as risk less trading. An arbitrager makes profit through the currency spread. Let’s understand this with the help of an example. Say the currency pair USDINR in India is trading at 1USD = 70 rupee and in America the same currency pair is trading at 1USD = 65 rupee. In such a situation the arbitrager would sell the currency in the Indian market and buy the same currency pair in the U.S market. As the prices converge to one particular value the arbitrages makes profit of 5 rupee which was the difference in both the markets, thus making a riskless profit. The convergence of prices is inevitable. This is because when the market participants will see that the price of rupee in the U.S market is cheaper than in India they would prefer to purchase from the U.S market at a cheaper rate. Similarly, as the rupee is expensive in the Indian markets participants would sell it in the Indian market.
When a market participant purchases high interest bearing securities from a foreign market to earn higher profits we call it as an uncovered arbitrage. However in such an arbitrage an investor can end up earning losses if there is depreciation in the foreign currency. For example, if an Indian investor invests in Bangladesh market to earn 2% extra interest then it is possible only if the Bangladesh Taka doesn’t depreciate further. If Taka depreciates more than 2 % then the investor will actually incur a loss in such a
kind of arbitrage.