If you are Canadian and you buy or sell U.S. stocks, you need to remember that arbitrage in the stock market is your friend, all the more so when it has an assist from AI, or Artificial Intelligence.

Arbitrage is the simultaneous purchase and sale of an asset in different markets, to exploit tiny differences in prices. We take advantage of it for our Portfolio Management clients whenever we can, to cut their trading costs. Here’s how it works:

If we’re selling a Canadian stock for a client and plan to use the proceeds to buy a U.S. stock, we offer the Canadian stock (on a Canadian or U.S. exchange) for sale in U.S. funds. When we want to sell a U.S. stock to buy Canadian, we reverse the order and offer the U.S. stock for sale in Canadian funds.

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Now that you can buy and sell in either currency on both sides of the border, arbitrageurs (also known as “arbs”—traders who buy and sell in two different currencies simultaneously) constantly monitor trading activity to spot slight differences in one currency versus the other. When they spot any such difference, they simultaneously buy the stock where it’s cheaper and sell it where it’s more expensive, eking out a tiny profit on the difference.

This trading activity serves to cut cross-border share-price differences to the point where they are, for practical purposes, negligible. This makes the markets more liquid. It cuts trading costs for everybody.

Years ago, switching from U.S. to Canadian stocks (or vice versa) was a two-step process. You had to sell the stock you wanted out of, then convert the proceeds from the one currency to the other, then make the desired stock purchase. This was much more expensive and time consuming than our current system. Currency conversations could eat up as much as 2% of your capital, or more. On top of that, you still had to pay the commission costs of two transactions (a sell and a buy).

We understand that some brokers still carry out these cross-border trades the old two-step way. That way, they profit from the currency conversion, which adds to the broker’s revenues and the clients’ costs.

Decades ago, arbs employed clerks who would scour trading activities for ‘mispricings’—trading opportunities. Instead of clerks, arbs now rely on AI software to spot mispricings and carry out potentially profitable trades, buying in one currency and selling in the other simultaneously.  This yields a tiny per-share profit to the arb, and a benefit to the trading public.

Here’s another aspect of cross-border investing that investors sometimes ask about:

Q: When buying a U.S. stock, would that stock then have to rise 26% to cover the exchange rate before I realized any gains? Thanks.

A: The short answer is no. That’s because you pay more in Canadian dollars when you buy U.S. stocks, but you get more Canadian dollars back when you sell.

Let’s say you want to buy a U.S. stock trading at $100 U.S.

This would cost you $136 in Canadian dollars at today’s exchange rate.

Let’s say the stock rose 5%, to $105 U.S.

If you sold it, and the exchange rate remained the same, you would get $143.08 in Canadian dollars.

That’s also an increase of roughly 5%.

At the same time, exchange rates do change. If the value of the U.S. dollar rises in relation to the Canadian dollar while you hold a U.S. stock, then you would get more Canadian dollars back when you sell than if the exchange rate had remained the same.

On the other hand, if the value of the U.S. dollar falls in relation to the Canadian dollar while you hold a U.S. stock, then you would get fewer Canadian dollars back when you sell than if the exchange rate had held steady.

Uncertainty over the direction of the U.S.-Canadian exchange rate may seem like a risk factor. However, the U.S. market offers investment opportunities that simply do not exist in the Canadian market; the Canadian market also offers investment opportunities that the U.S. market lacks.

We see holding U.S. stocks in your portfolio, and thereby gaining U.S. dollar exposure, as a long-term plus. The two currencies go through random daily fluctuations. But in the long term, holding stocks from both sides of the border is a valuable form of diversification.

What are your thoughts on this? Is arbitrage in the stock market your friend? What has been your experience?