The theory of market efficiency tells us there is no opportunity for arbitrage in the FOREX market. It tells us there is no opportunity to make money or acquire a higher rate of return as the current and future exchange rates already take into account differences in each countries interest rates and levels of inflation. While the market promises to be perfectly efficient, it sure forgets about this sometimes. It is not an everyday event where you will notice a price discrepancy that can be used in your favor, it is also not a rare event. There are just a couple things to look for in order to find opportunities for arbitrage.
Interest Rates are the first factor that exchange rates are constantly reacting to. While many different interests rates are at play, the most pivotal in the risk free rate in each country, usually determined by the rate of return for short term government bonds. If market efficiency holds true the relationship between the spot and the future rate can be determined by the Interest Rate Parity equation. Lets say we are looking at the spot and futures exchange rates for buying Euros with Dollars. The equation tells us with complete efficiency: Futures Rate/Spot Rate = (1+Euro interest rate)/(1+Dollar interest rate). If these two do not equate then that is good news for us, meaning arbitrage is possible. If the right side of the equation is larger then we should buy Euros, invest them at the risk free rate, then convert them back to Dollars in a year with a futures contract that locks in a price. This strategy makes our investment more profitable than simply investing Dollars in our own country. Since these rates are readily available to all investors, this is a very possible investment strategy for just about anyone.
Inflation rates on the contrary are not as easy to find to the average investor. What we can use as a proxy for each countries inflation rate is the CPI or consumer price index. We can simply find the percentage change of the CPI from year to year and this is our inflation rate for that year. With this we have a similar equation that produces equality in a completely efficient market. That theory is Relative Purchasing Power Parity, for a simple such example we have the following equation: Futures Rate/Spot Rate = (1+Euro interest rate)/(1+Dollar interest rate). With this equation however if the left side is larger we should buy Euros and convert them back to dollars in a year with a futures contract. If this is the case we can achieve a higher rate of return by investing in European securities with Euros as opposed to domestic investments.
The really interesting part is that if we have a perfect storm of Interest rates and Inflation rates we can get the effects of both relations. This is very rare but provides great value to a currency trader as well as all other investors. While these opportunities do not arise often enough to fuel your entire investment strategy, it can definitely bump your interest rates when the opportunity comes along. Don’t waste these opportunities and make sure to take advantage of any discrepancies where the market efficiency has not kicked in!