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# Triangular Arbitrage The previous sections showed how we can calculate cross rates from two other currency

Sell 1,000,000 USD and buy 1,165,100 CAD in New York (Remember, if we exchange the base currency for the quote currency we multiply by the quote.) Sell the 1,165,100 CAD and buy 1,302,116 CHF in Frankfurt (Again, moving from CAD to CHF we must multiply by the quote.) Sell 1,302,116 CHF and buy 1,001,012 USD in London (As we move from quote currency to base currency we must divide by the quote.) These actions can be better understood by Figure 2-4, which demonstrates the process of triangular arbitrage: Figure 2-4: Triangular Arbitrage

The arbitrageur nets a profit of \$1,012 by going through the above three legs of the triangle. In reality, each step will not be taken individually as the arbitrageur would be exposed to execution risk the risk of the quotes moving adversely during the time to set up the next trade. Instead, once the computer program flags the opportunity, the arbitrageur would enter the following trades simultaneously: Sell 1,000,000 USD/CAD in New York Sell 1,165,100 CAD/CHF in Frankfurt Buy 1,001,102 USD/CHF in London

These actions put the following pressures into action: 1. Selling pressure on the USD in New York. The quote will eventually FALL below USD/CAD = 1.1651 2. Selling pressure on the CAD in Frankfurt. The quote will eventually FALL below CAD/CHF = 1.1176 3. Buying pressure on the USD in London. The quote will eventually RISE above USD/CAD = 1.3008 The arbitrageurs are exchanging USD for CAD, then CAD for CHF, and then CHF for USD. These actions leave the arbitrageur back with same currency unit that he stated with:

New York: USD/CAD = 1.1651 Frankfurt: CAD/CHF = 1.1176 London: USD/CHF = 1.3008

The actual quote for USD/CAD is 1.1646, which is lower than the 1.1648 quote we used in the arbitrage example. This would be due to the selling pressure in New York in our hypothetical example. The actual quote for CAD/CHF is 1.1173, which is also lower than the 1.1176 quote we assumed in the arbitrage example. This reduction would be due to the selling pressure we assumed in Frankfurt. The actual quote for USD/CHF is 1.3012, which is higher than the 1.3008 exchange rate we used, which is due to the assumed buying pressure in London. So even though the numbers we chose for the arbitrage example were hypothetical, they still show an important point. That is, if those hypothetical numbers were real, they would be forced toward the actual values we find in Table 2-1. Arbitrageurs will make sure of it. Are the quotes in Table 2-1 perfectly in line at the given quotes? If we run through the same steps using the actual quotes in Table 2-1, we find that the arbitrage profit has been reduced to only \$6: Take 1,000,000 USD and exchange them for 1,164,600 CAD in New York

Take the 1,164,600 CAD and exchange them for 1,301,208 CHF in Frankfurt Take the 1,301,208 CHF and exchange them for 1,000,006 USD in London The reason for this small discrepancy is that we havent taken into consideration the bidask spreads for these quotes. If we did, you can be sure that there are no significant arbitrage opportunities in Table 2-1. Arbitrage is not possible at the retail level because the size of the necessary transactions would be very large and you would need proprietary computer programs to find and exploit the opportunities. Arbitrage is still important to understand since it is the process that keeps prices in line with theoretical prices and therefore makes all cross rates fairly priced.