International Arbitrage: Definition, Types & Examples

Key Highlights

• Arbitrage occurs when a security is purchased on one market and sold on another at a higher price.

• Traders can profit from a temporary difference in the prices of identical assets in both markets.

• Arbitrage trading is seen as a relatively low-risk activity.

Understanding International Arbitrage Meaning

Purchasing and selling identical amounts of assets in two separate markets is called "international arbitrage". The principle of price differentials created by market inefficiency is exploited by international arbitrage. International arbitrage is where a trader buys a security from one market at a lower price and sells the same security on another market at a higher price to make a riskless profit.

If both markets are located in the same country, it could be described as "an arbitrage transaction", but according to ​the definition of ​​i​nternational ​a​rbitrage, these two markets should exist within different countries. Due to price differentials reaching equilibrium as soon as they are detected, international arbitrage opportunities are scarce. There will be no place for international arbitrage if there is a price equilibrium on the market. The purchase and sale of American depositary receipts (ADRs), currencies​,​ or the same stock listed in two countries represent the most prominent type of foreign arbitrage trading.

Why International Arbitrage Occurs

International arbitrage occurs when the same asset, such as a stock or commodity, is priced differently in two markets due to variations in supply-demand conditions, local investor sentiment, or currency movements. Traders may purchase the asset in the market where it is cheaper and sell it where it is more expensive, earning a profit without taking directional market risk. Such situations often arise because market prices do not adjust instantly across borders, influenced by time zone differences, trading regulations, and variations in transaction speeds. While technology has reduced these gaps, they still occur in less liquid markets or after sudden events that affect one region before another.

Arbitrage opportunities can also emerge when certain financial products, such as derivatives or exchange-traded funds (ETFs), are restricted or taxed differently across countries. In markets where such products trade at a discount due to local restrictions, they may be sold at higher prices in more open markets. These differences can result from capital controls, varying disclosure rules, or differences in transaction cost structures.

A thorough understanding of the legal framework is necessary, as compliance with regulations in both jurisdictions is essential. Regulatory-driven pricing gaps can close quickly, particularly when policy changes are announced.

Types of International Arbitrage

The three main types of international arbitrage are interest arbitrage, two-point arbitrage, and triangular arbitrage. Let's look at them in detail:

1. Covered Interest Arbitrage

It is known as covered interest arbitrage when the trader uses a forward contract to hedge against exchange rate risks while investing in higher-yielding currencies. The words 'cover' and 'interest arbitrage' are used in a covered interest arbitrage, which means hedging against currency fluctuations while exploiting rate differentials. Complex trading operations and sophisticated arrangements are required in the covered interest arbitrage.

2. Two-point Arbitrage

A two-point arbitrage is an efficient trading technique in which traders buy and sell securities on one market at a higher selling price across geographically different markets. The exchange rate of a currency should be the same worldwide, as far as classical economic theory is concerned. However, there is a price differential due to certain factors, such as the difference in time zones and the lag in the exchange rate. A trader will benefit from the situation by buying or selling on a market that is more advantageous to him than one in which it is cheaper. The exchange rate must be higher than the transaction cost for a gain.

3: Triangular Arbitrage

A more complex form of two-point arbitrage is triangular arbitrage, also known as three-point arbitrage. Instead of two, this involves three currencies or securities. In cases where the exchange rates of three different currencies are at variance, there is a triangular arbitrage opportunity.

In a three-point international arbitrage, the trader sells currency A to buy currency B, then sells B to purchase C, and finally sells C to return to A. Suppose these price differences exist across markets, the trader can lock in a risk-free profit by completing all three legs of the transaction.

Risks and Challenges in International Arbitrage

International arbitrage carries the following risks:

• Exchange Rate Volatility

Exchange rate movements can quickly alter expected profits. Even minor changes in currency value between trade execution and settlement may turn gains into losses. This risk tends to be higher in emerging markets, where currency fluctuations are often more unpredictable.

• Settlement Timing Mismatches

Different settlement periods across markets can create gaps in exposure. For example, one exchange may settle trades within two days, while another may require five. During this interval, market and currency fluctuations can occur, potentially undermining the arbitrage strategy before both trades are finalised.

• Transaction Cost Discrepancies

Arbitrage profits are often narrow, making them highly sensitive to transaction costs. These include brokerage fees, clearing charges, currency conversion spreads, and taxes, which can vary significantly between markets. Lower commissions on one exchange may be offset by higher foreign exchange costs, affecting net returns.

• Time Zone Constraints

Differences in time zones can complicate execution, as market hours rarely align perfectly. Trades may need to be placed outside regular working hours, increasing the possibility of operational errors. Delays may also occur when one market reacts to price changes while the other remains closed.

• Political Uncertainty

Political developments such as elections, protests, or policy changes can impact markets and currencies. Sudden implementation of capital controls, trade restrictions, or new tax laws can occur without warning, directly influencing the outcome of existing arbitrage positions.

• International Arbitrage Example

Let's see what international arbitrage is all about. For instance, the stock of XYZ Inc. is traded on both the New York Stock Exchange and the National Securities Exchange. XYZ's shares are trading on the National Stock Exchange at Rs. 500. However, shares traded at $10.5 per share on the New York Stock Exchange. We assume the exchange rate of USD/INR is 50, which means 1 US$ = Rs 50. The price of shares on the NYSE in INR will be equal to 525 Indian rupees if the exchange rate is current.

In such a case, an investor can simultaneously buy and sell shares of XYZ on the NSE and the New York Stock Exchange to make a profit of 25 paise per share. In reality, however, the difference is minimal, and ensuring that the favourable exchange rate is maintained for a certain period is necessary. Considering the transaction costs when making an international ​arbitrage ​decision is crucial. High transaction costs may offset the benefits of arbitrage.

Types of Statistical Arbitrage Strategies

Many strategies are classified as statistical arbitrage trading, as mentioned below.

1. Market Neutral Arbitrage

This strategy focuses on taking long positions in an undervalued asset and shorting it simultaneously. The long position is expected to increase in value, while the short position will decrease, and the increase and decrease will be the same.

2. Cross-market Arbitrage

This model considers differences between the same asset on several markets.

3. ETF Arbitrage

This is a cross-asset arbitrage technique whereby differences between an ETF's valuation and its underlying assets are detected. This is done to guarantee that the price of the ETF corresponds with the value of the underlying assets.

4. Cross-asset Arbitrage

This model considers the price difference between an asset and its underlying.

Conclusion

Statistical arbitrage in international finance is based on extensive data and mathematical and algorithmic models to exploit price differences between securities. It is based on short-term mean reversion, whereby the price differences up to the point of reversion to the mean levels are considered. To start stock trading or to open a demat or trading account, check out Kotak Securities.