In the foreign exchange market, one of the easiest ways to make money is by utilizing a technique known as currency arbitrage. Arbitrage involves exploiting the difference between the prices of different assets, such as stocks, bonds or in the case of foreign currency exchange, currency exchange rates. Traders who deal in arbitrage, known as arbitrageurs, watch the foreign exchange markets like a hawk in order to find opportunities to exploit differences in exchange rates.
Here is a common opportunity that involves three currencies and is relatively simple to understand. Imagine a situation involving the United States dollar, the Euro and the Swiss franc. The exchange rate between the dollar and the Euro is 1.5, the exchange rate between the Euro and the Swiss franc is .2, and the exchange rate between the Swiss franc and the dollar is 5. Obviously, this arrangement rarely arises but for the purposes of this example it is enough.
When traders use currency arbitrage, they look at the exchange rates of different currencies and look for trades that will make them a profit. This not only profits them but also reduces the exchange rate back to normal levels. So, a hypothetical investor sees the situation outlined above and decides to make their move.
First, they exchange their $10,000 for fifteen thousand Euros. Then, the trader exchanges his fifteen thousand Euros for three thousand Swiss francs. Finally, they finish the trade by exchanging three thousand Swiss francs for $15,000. Thus the investor has made a profit of $5,000.
When dealing with currencies, this kind of investment is very different from an investment property mortgage, for instance. Currency traders have to pay attention to every dip and rise in the market as well as the geopolitical situation across many countries in order to take advantage of rapidly shifting situations. Currency trading is thus a hair-raising exercise for the emotional and needs a level head in order to fully take advantage of the opportunities that await.
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