Arbitrage and Speculation by Ahmad Kamil and Muhafiz

Arbitrage and Speculation 

by Ahmad Kamil and Muhafiz

WHAT IS FOREX?

Forex is a commonly used abbreviation for "foreign exchange". It typically describes the buying and selling of currency in the foreign exchange market, especially by investors and speculators. The familiar expression, "buy low and sell high," certainly applies to currency trading. A forex trader purchases currencies that are undervalued and sells currencies that are overvalued; just as a stock trader purchases stock that is undervalued and sells stock that is overvalued.

ARBITRAGE IN FOREX

The factor underlying the consistency of the exchange rates is called exchange arbitrage. Exchange arbitrage refers to the simultaneous purchase and sale of a currency in a different foreign exchange markets in order to profit from exchange rate differentials in the two locations. This process brings about an identical price for the same currency in different locations and thus results in one market.  

Two point arbitrage – which two currencies are traded between two financial centers.

Three point arbitrage – involving three currencies and three financial centers or more.

Example: Figure 1

	Two point arbitrage		Three point arbitrage
MYR –> USD	10,000.00 = 2,493.95	MYR –> USD	10,000.00 = 2,493.95
USD –> MYR	2,493.95 = 10,004.78	USD –> JPY	2,493.95 = 271,766.72
PROFIT/(LOSS)	4.78	JPY –> MYR	271,766.72 = 10,004.469
		PROFIT/(LOSS)	4.469

MYR = Ringgit Malaysia, Malaysia

USD = US Dollar, United States

JPY = Yen, Japan

Based on figure 1, for two point arbitrage we are given RM10,000 to make exchange foreign. We change MYR to USD and we get $2493.93. At London, $2493.93 equal to RM10,004.78. So we make profit RM4.78.

For three point arbitrage, we use same amount. We change MYR to USD and we get $2493.93. At London, we get $2493.93. After that, we transfer USD to JPY. In Japan, we get 271,766.72yen. After that, we transfer back to MYR and we get RM10,004.469. So the profit we make is RM4.469.  

WHAT IS 'SPECULATION

Speculation is the act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain. With speculation, the risk of loss is more than offset by the possibility of a huge gain otherwise, there would be very little motivation to speculate. While it is often confused with gambling, the key difference is that speculation is generally tantamount to taking a calculated risk and is not dependent on pure chance, whereas gambling depends on totally random outcomes or chance.

Speculation in Forex

Speculation is the attempt to profit by trading on expectations about prices in the future. Some speculators are traders acting for financial institutions or firms, others are individuals. In either case, speculators buy currencies that they expert to go up in value and sell currencies that they expect to go down in value. In the foreign exchange market, speculators dominate close 90 percent of daily trading volume is speculative in nature.

Stabilizing and Destabilizing Speculation

Stabilizing – Purchase of foreign currency when the exchange rate falls in the expectation that will soon rise, thus leading to profit. Sale of foreign currency when exchange rate rises in the expectation that it will fall soon. Stabilizing speculation moderates the fluctuations in exchange rate and performs a useful function.

Destabilizing – Sale of foreign currency when exchange rate is low in the expectation that it will fall even further. Purchase of foreign currency when exchange rate raising in the expectation that it will rise even higher in future.

Difference between Arbitrage and Speculation

Arbitrage – A currency trader simultaneously buys a currency at a low price and sells that currency at a high price, thus making a riskless profit

Speculation – Buy a currency at one moment and sell that currency at a higher price in future.

Speculation thus implies the deliberate assumption of exchange risk. If the price of the currency falls between today and tomorrow, the speculator loses money. An exchange market speculator deliberately assumes foreign exchange risk on the expectation of profiting from future changes in the spot exchange rate.