Geographic Arbitrage Trading Strategy
Geographic arbitrage is a trading strategy that exploits price discrepancies of financial instruments, commodities, or assets in different geographical markets.
This approach finds inefficiencies in pricing due to various factors such as time zones, market regulations, and economic conditions.
Key Takeaways – Geographic Arbitrage Trading Strategy
- Geographic arbitrage exploits price differences for the same asset across different markets or exchanges.
- Traders can capitalize on time zone differences and market inefficiencies to try to secure risk-free profits.
- Efficient execution and low transaction costs are very important for successfully implementing geographic arbitrage strategies.
- We give some example trades below.
Key Concepts
Price Discrepancies
Price discrepancies occur when an asset is traded at different prices in different locations.
These discrepancies can be due to a variety of reasons including:
- differing supply and demand dynamics
- local market conditions, and
- trading hours
Market Inefficiencies
Market inefficiencies arise from the inability of all market participants to access the same information simultaneously.
Geographic arbitrage traders take advantage of these inefficiencies by buying low in one market and selling high in another.
In the 18th and 19th centuries, one of the first popular instances of insider trading occurred when investors in New York would hear financial news and then use steamboats to travel down south to buy bonds, exploiting the information before it became widely known.
How Geographic Arbitrage Works
Identifying Opportunities
Traders look at multiple markets to identify price differences for the same asset.
This requires real-time data analysis and, these days, quality algorithms to detect arbitrage opportunities quickly.
Very little arbitrage in public markets is still done in a discretionary way (though it of course still happens).
Executing Trades
Once an opportunity is identified, traders simultaneously execute buy and sell orders in the respective markets.
The goal is to profit from the spread between the purchase price and the selling price, minus any transaction costs.
Factors Influencing Geographic Arbitrage
Time Zones
Different time zones mean that markets open and close at different times.
Traders can exploit these differences by trading in markets that are open while others are closed.
Regulatory Differences
Regulations vary by region and can affect market prices.
Traders must understand these regulations to exploit price differences.
Some startup companies are also founded on the idea of “regulatory arbitrage.”
Economic Conditions
Local economic conditions, such as interest rates and inflation, can impact asset prices.
The same asset might be valued differently in different countries accordingly.
The “Big Mac Index” is a tongue-in-cheek example of the price differential of a popular consumption item between countries.
Geographic arbitrage traders analyze these conditions to predict price movements.
Challenges in Geographic Arbitrage
Transaction Costs
High transaction costs, including spreads, fees, and taxes, can erode the profits from arbitrage opportunities.
Traders must factor these costs into their calculations.
Market Access
Accessing multiple markets requires sophisticated infrastructure and technology.
Not all traders have the resources to operate in various geographical locations.
Speed and Timing
The window of opportunity for geographic arbitrage can be very short.
Examples of Geographic Arbitrage
Currency Arbitrage
Currency arbitrage involves buying a currency in one market where it is undervalued and selling it in another market where it is overvalued.
Commodity Arbitrage
Commodity arbitrage takes advantage of price differences for commodities such as oil, gold, or agricultural products between different geographical markets.
Let’s look at some trades involving geographic arbitrage:
Example 1: Currency Arbitrage
Scenario
A trader identifies a price discrepancy in the exchange rate of the Euro (EUR) against the US Dollar (USD) in two different markets: New York and London.
Identify Price Discrepancy
Example prices:
- New York Market: 1 EUR = 1.2000 USD
- London Market: 1 EUR = 1.2020 USD
Determine Trade Amount
Trader decides to trade 1,000,000 EUR.
Execute Buy Order in New York
- Buy 1,000,000 EUR at 1.2000 USD.
- Cost in USD = 1,000,000 * 1.2000 = 1,200,000 USD.
Execute Sell Order in London
- Sell 1,000,000 EUR at 1.2020 USD.
- Revenue in USD = 1,000,000 * 1.2020 = 1,202,000 USD.
Calculate Profit
- Profit = Revenue – Cost = 1,202,000 USD – 1,200,000 USD = 2,000 USD
Example 2: Commodity Arbitrage
Scenario
A trader identifies a price discrepancy in the price of crude oil between the Tokyo Commodity Exchange (TOCOM) and the New York Mercantile Exchange (NYMEX).
Identify Price Discrepancy
- TOCOM Price = 70 USD per barrel
- NYMEX Price = 72 USD per barrel
Determine Trade Amount
Trader decides to trade 10,000 barrels of crude oil.
Execute Buy Order in Tokyo
Buy 10,000 barrels at 70 USD per barrel.
- Cost in USD = 10,000 * 70 = 700,000 USD.
Arrange Transportation (if applicable)
Consider the cost of transporting the oil from Tokyo to New York.
Assume transportation cost is 1 USD per barrel.
- Total transportation cost = 10,000 * 1 = 10,000 USD.
Execute Sell Order in New York
Sell 10,000 barrels at 72 USD per barrel.
- Revenue in USD = 10,000 * 72 = 720,000 USD.
Calculate Profit
- Profit = Revenue – (Cost + Transportation) = 720,000 USD – (700,000 USD + 10,000 USD) = 10,000 USD.
Why are the prices of WTI and Brent oil different?
The prices of WTI (West Texas Intermediate) crude and Brent crude differ due to:
- variations in their physical properties
- regional supply and demand dynamics, and
- transportation costs
WTI is lighter and sweeter, making it easier to refine into gasoline, while Brent is more globally distributed and influenced by broader geopolitical factors.
These factors create distinct market conditions for each crude type.
Price differentials between WTI and Brent are not genuine arbitrage opportunities.
Example 3: Stock Arbitrage
Scenario
A trader identifies a price discrepancy in the stock price of Company XYZ between the Frankfurt Stock Exchange and the New York Stock Exchange (NYSE).
Identify Price Discrepancy
- Frankfurt Stock Exchange = 100 EUR per share
- NYSE = 105 USD per share
- Exchange rate = 1 EUR = 1.20 USD
Determine Trade Amount
Trader decides to trade 5,000 shares of Company XYZ.
Convert Currency
Calculate the equivalent price in USD for Frankfurt: 100 EUR * 1.20 USD/EUR = 120 USD per share.
Execute Buy Order in Frankfurt
Short-sell 5,000 shares at 100 EUR per share.
- Cost in EUR = 5,000 * 100 = 500,000 EUR
- Convert cost to USD = 500,000 EUR * 1.20 USD/EUR = 600,000 USD
Execute Sell Order in New York
Buy 5,000 shares at 105 USD per share.
- Revenue in USD = 5,000 * 105 = 525,000 USD.
Calculate Profit
- Profit = Revenue – Cost = 600,000 USD – 525,000 USD = +75,000 USD
Consideration of Arbitrage Viability
This example highlights the importance of making sure the arbitrage opportunity is genuine.