In the current economic climate, where many countries are experiencing sluggishness and even recession, Japan’s economy has strengthened. This is particularly true since Shinzo Abe came to power in 2012 and implemented his Three Arrows’ policies built on quantitative easing, fiscal stimulus, and structural reforms.
What is currency arbitrage?
Currency arbitrage is where an investor takes advantage of the difference in the same reasonable price in two different markets. The idea is that if you can buy a currency for $1.00 at one location and sell it for $1.10 at another site, you can turn a profit by buying low and selling high while taking on little risk due to hedging methods employed during the transaction process.
Currency arbitrage is a popular investment strategy for those who wish to earn higher returns or yields from their investments by buying an asset that is currently cheap in one market and simultaneously selling it at a high price in another market where its value is comparatively lower.
But what does this mean, exactly? And how can you conduct such transactions?
To give you an example of how currency arbitrage works, you buy 1000 USD in the US at the spot price of 1 dollar = 100 yen. Then you go to Japan and sell your dollars at the spot price of 1 dollar = 120 yen.
You will end up gaining 20 dollars, which is about 1600 yen after the exchange rate adjustment (plus or minus depending on any fees that may be applied).
This type of investment has been mainly popularised through movies such as Ocean’s 11 or Trading Places. In practice, however, the nature of currency marketplaces make this concept difficult to execute unless one employs highly specialized techniques.
Let’s explore how currency arbitrage works in Japan after the advent of Abenomics and clear up misconceptions of how it can be done.
Currency arbitrage is one of the most talked-about investment techniques in Japan at the moment, though not nearly as popular as other forms like cross-shareholdings or foreign direct investments (FDI). For some reason, there seems to be quite a bit of confusion.
Misunderstanding that currency arbitrage entails
The first issue that must be addressed is that investors need to find two currencies with price discrepancies; they need to find two markets where buy prices are different but sell prices are the same.
Arbitrage takes advantage of two different prices, and thus it is necessary to separate currency exchanges from stock markets to avoid overlapping buy and sell orders. When someone saves money in yen at a Japanese bank, that person is not making an arbitrage transaction.
On the other hand, if that person buys foreign currency through a broker such as GMO Click Securities, they can make an arbitrage transaction by selling it for 10 yen more than what was paid.
The second issue is with misaligned incentives between market participants. Sometimes when companies participate in currency exchanges (more on this below), they try to profit from the spread rather than through trading fees.
This means maintaining two price structures: one intended for investors and another designed to benefit from currency exchanges.
For example, some banks have been found to offer foreign currency at a price slightly higher than the market value as part of their service fees.
In this case, they are making more money from those who buy foreign currency for business use than those who believe it is an investment.
This is because companies do not have financial incentives to drive down the price on the buy-side to sell for a higher price on the sell-side.
It can be challenging for market participants to see where prices meet up due to differences between investors’ understanding of “the spread”.
One unknowing investor might place a large buy order at a price that includes his purchase and a fee for foreign currency.
Meanwhile, another investor with a smaller order might place a buy order at a lower price than the purchase but still includes fees.
Neither party will execute their transaction until they agree on an identical spread. This results in forced execution prices that may not be the best deal for either trader.
This means that arbitrage via options contracts cannot work in Japan due to these two factors: stock exchanges and misaligned incentives between market participants.
This is why big institutions can take advantage of arbitrage opportunities through currency futures or forward contracts. When reading about significant corporations profiting off of this trend, it seems like they got lucky by buying at the right time.
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