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Meaning of Two Point Arbitrage
Buying a currency in one market and selling it at higher price in another geographically different market is called two-point arbitrage.
Normally exchange rate for a given currency should be same in every part of the world. However, due to some discrepancies in the market the prices might be differ in various markets and in such case, arbitrageur would buy the currency in the market where its price is lower and then sell the currency in the market where its price is higher.
If the exchange rate differential is higher than the transaction cost, an arbitrage profit can be made.
Two point arbitrage is totally different from Covered Interest Arbitrage, where arbitrager takes advantage of interest rate differential between two countries.
Do Remember:
What would be no arbitrage condition for two currencies?
- Bid rate of one bank = ask rate of another bank
- Ask rate of one bank is above bid rate of another bank
Example of Two Point Arbitrage
ICICI BANK 1$ = Rs. 70.54 / Rs. 70.60 – London Market
CITI BANK 1$ = Rs. 70.62 / Rs. 70.65 – US Market
Now we have above two quotes from two banks for US$ and You Mr., you are an arbitrager and you have to find out the way to make profit.
Ans: –
No arbitrage condition-
- Bid rate of one bank = ask rate of another bank
- Ask rate of one bank is above bid rate of another bank
In above example bid rate of CITI Bank is not equal to Ask Rate of ICICI Bank and Ask rate of ICICI Bank is lower than the bid rate of CITI Bank. As the condition of no arbitrage not satisfied therefore here there is a chance for an arbitrage.
As an arbitrager I will buy the $ from ICICI Bank at Rs. 70.60 and sell it to CITI Bank at Rs. 70.62 and I will make profit of Rs. .02 (70.62 – 70.60).
Special Note
Let’s understand two point arbitrage in other simple way. Listen if you are buyer and you have two options to buy a product then it’s obvious you will definitely go for that option which will cost you less. Similarly, if you are seller and you have two options to sell a product then you will definitely go with that option that give you more money.
As a buyer you always want to buy at less and sell high.
Similarly, in above example we need to buy at less price and sell the same product at higher price, so that we can make profit.
As a buyer the relevant rate for us is Ask Rate because we can buy at the price on which market wants to sell. In above example compare ask rate of both the bank and pick lower one i.e. 70.60 from ICICI Bank. Now you have to sell it and, in this case, relevant rate is bid rate. Compare the bid rate and pick higher one i.e. 70.62 from CITI Bank.
As I am able to buy at lower rate and sell at high rate that means arbitrage is possible and I can make profit.
