Arbitrage can be defined as capitalizing on a discrepancy in quoted prices. The funds invested are not tied up and no risk is involved. In response to the imbalance in demand and supply resulting from arbitrage activity, prices will realign very quickly, such that no further risk-free profits can be made.

Locational arbitrage is the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. Locational arbitrage is possible when a bank‘s buying price (bid) is higher than another bank‘s selling price (ask) for the same currency.

Triangular Arbitrage in which currency transactions are conducted in the spot market to capitalize on a discrepancy in the cross exchange rate between two currencies. This is possible, if quoted cross exchange rate differs from the appropriate cross exchange rate.

When the exchange rates of the currencies are not in equilibrium, triangular arbitrage will force them back into equilibrium.

Covered Interest Arbitrage is the process of capitalizing on the interest rate differential between two countries, while covering for exchange rate risk. Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials.

As many investors capitalize on covered interest arbitrage, there is Upward pressure on the spot rate and Downward pressure on the 90-day forward rate. Once the forward rate has a discount from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage will no longer be feasible.

Interest Rate Parity (IRP)

Sometimes market forces cause the forward rate to differ from the spot rate by an amount that is sufficient to offset the interest rate differential between the two currencies. Then, covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP).

When IRP exists, it does not mean that both local and foreign investors will earn the same returns. What it means is that investors cannot use covered interest arbitrage to achieve higher returns than those achievable in their respective home countries.