how outward arbitrage works
outward arbitrage is a key concept in modern finance modern financial theory is based on the idea that pure arbitrage a system whereby an investor or company can take advantage of price differentials to make money without fail doesn t actually happen for sustained periods academic finance suggests that a true arbitrage opportunity would disappear almost instantly as investors enter that market and compete over these easy profits but the real world does not always follow economists models and some arbitrage opportunities do occur in the actual markets as the result of imperfect competition for instance it is not easy for just any bank to scale up to the point that it can take advantage of cross border differences in interest rates due to regulation and imperfect markets for financial services this lack of competition makes it possible for outward arbitrage opportunities to persist for those banks already in the position to leverage significant assets into what they consider to be profitable arbitrage dealings outward arbitrage and the eurodollar marketoutward arbitrage was a phrase coined in the middle of the twentieth century because of the strong demand for savings accounts abroad that were denominated in u s dollars these savings deposits were referred to as eurodollars because all of the foreign dollar denominated accounts were at that point housed in europe today however eurodollars can be purchased in many countries around the world outside of europe the eurodollar market took off after 1974 when the united states lifted capital controls that hampered lending across borders since that time the eurodollar market has become an important source of funding and profits for u s banks due to the lack of requirements for eurodollars having a large supply can be extremely valuable in the outward arbitrage market especially when traditionally leveraged assets like cds experience low liquidity banks can also dip into the eurodollar market to borrow funds to engage in outward arbitrage if the reserve requirements or interest rates are more desirable in the eurodollar market when compared to domestic sources of funding an example of outward arbitragelet s say that a large american bank wants to make money through outward arbitrage let s also assume that the going rate for one year certificates of deposit in the united states is 2 while dollar denominated certificates of deposit are paying 3 in france the large american bank could decide to make money by accepting certificates of deposits in the united states and then taking the proceeds to issue loans in france at a higher rate inward arbitrage is possible when the situation is reversed and interest rates are higher in the united states than abroad outward arbitrage vs inward arbitrageoutward arbitrage differs fundamentally from inward arbitrage inward arbitrage can be considered the opposite side of outward arbitrage when higher rates exist abroad a bank would engage in outward arbitrage when the domestic rates are higher a bank would then borrow the money from the international market depositing it domestically in order to take advantage of the rate discrepancy banks will engage in both outward and inward arbitrage based on the fiscal environment and ability to profit at incredibly low risk due to the near zero tolerance for risk when considering inward arbitrage a certificate of deposit cd is usually the preferred method of fund transfer cds despite their low interest rates when compared to other investment vehicles are some of the safest investments to make when banks engage in arbitrage they are doing so with significant amounts of money therefore the appetite for risk is extremely low 