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

quotes. This shows that there is a connection between currency pairs and cross rates. Are there any procedures set in place to be sure the cross rate quotes do not get out of line from the rest? The answer is yes. The people in charge of making sure the prices do not get too far out of line are called arbitrageurs. Arbitrage is from the French arbitrer, which means to judge. It is also where we get the word arbitrator from. Arbitrageurs are speculators in the market who make free money by judging the relative values between assets. And free money is a powerful incentive for someone to keep a watchful eye on prices. By placing simultaneous trades, arbitrageurs can capture money for no risk (called an arbitrage profit) in the marketplace. To qualify as an arbitrage profit, two conditions must be met. First, the profit must be guaranteed. Second, there can be no cash outlay on the part of the arbitrageur. This second condition is necessary otherwise an investment in a government bond would count as arbitrage since it results in a risk-free profit. For the arbitrageurs, they must gain this profit by not spending any money. The classic form of arbitrage involves the simultaneous buying and selling of the same security on two different exchanges. The arbitrageur buys the relatively cheap asset and, at the same time, sells the relatively expensive one. For instance, assume that IBM is trading for $100 on the New York Stock Exchange and is also trading for $100.10 on the Philadelphia Exchange. Realizing that the same asset is trading for two different prices, arbitrageurs would buy shares on the New York and simultaneously sell them on the Philly for a guaranteed 10cent profit. You might be wondering why anybody would bother for a 10-cent profit but arbitrageurs will send in orders for potentially tens of thousands of shares thus magnifying tiny price discrepancies into considerable gains. Their actions put buying pressure in New York (where IBM prices are low) and selling pressure in Philly (where IBM prices are high) thus bringing both prices closer together. The arbitrage opportunities cease to exist once IBM is trading for the same price on both exchanges. In the currency markets, arbitrageurs do a similar, although more complicated, process called triangular arbitrage. The word triangular is used to denote the fact that the arbitrageur must convert one currency into another on one exchange, then into another at another exchange, and then convert the currency back to the base currency at yet another exchange. This three step process represents each leg of a triangle. Lets take a look at an example, which well make easier by not considering the bid-ask spreads. Assume the following three sets of hypothetical quotes: New York: USD/CAD = 1.1651 Frankfurt: CAD/CHF = 1.1176 London: USD/CHF = 1.3008 Using computer programs, arbitrageurs would find that there are discrepancies among these quotes. To capitalize on these discrepancies, the arbitrageur may take the following steps:

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.

Triangular Arbitrage In Forex Trading


Foreign exchange is also known as forex or FX. Forex is the worlds largest financial market. Most of the trading focuses on this 7 currency which is US Dollar (USD), Euro (EUR), Japanese Yen (JPY), Great Britain Pound (GBP), Swiss Franc (CHF), Australia Dollar (AUD) and Canada Dollar (CAD). In finance, arbitrage is the action of taking advantage from the price difference between two or more markets. In other words, arbitrage is taking advantage on the imbalance that arises. In foreign exchange market, the exchange rate is based on the principle of triangular arbitrage. In competitive foreign exchange market, there should be no triangular arbitrage. What is triangular arbitrage? Triangular arbitrage is a process of converting one currency to another. Then, converting it again to a third currency and finally converting it back to the original currency within a short time span. Lets see below example that involves 3 currencies which is US Dollar (USD), Great Britain Pound (GBP) and Malaysian Ringgit (MYR). There are 3 foreign exchange rates quoted in the market which is: USD 1.50/GBP, GBP 0.15/MYR, MYR 3.00/USD Suppose you have cash USD1,000 and you follow below steps: 1. Use USD1,000 to buy GBP. Now you get GBP666.67. [= 1,000 / 1.50] 2. Then, use GBP 666.67 to buy MYR. You get MYR 4,444.47. [= 666.67 / 0.15] 3. Then, use MYR4,444.47 to buy USD. You get USD 1,481.49. [= 4,444.47 / 3] You use cash USD1,000 to buy the foreign exchange and with 1 round you get back USD1481.49. The profit is USD481.49. This is a very good profit for a minute work. This is the example of triangular arbitrage. Now, you know a method to make money by trading forex. If the triangular arbitrage opportunity arises, it is very easy to recognize. You can calculate whether the 3 foreign exchange rates are equal to 1. If it is equal or close to 1,

then the triangular arbitrage opportunity does not arises. If there is big difference from 1, then the opportunity had been arises. The calculation as below: USD/GBP x GBP/MYR x MYR/USD = 1 For above case, USD 1.5/GBP x GBP 0.15/MYR x MYR 3.00/USD = 0.675 which is not equal to 1. Then, the opportunity had been arises. If the result is close to 1 such as 1.00001 and 0.99998, then it may not profitable because the transaction cost will erode the profit. Will the triangular arbitrage opportunities exist in actual forex trading market? Yes! Anyway, triangle arbitrage opportunities seldom happened in actual foreign exchange market. It may exist for a few seconds only such as 1 or 2 seconds. This is because the dealers at the front line had set some computer programs to profit from the opportunity. If the opportunity arises the computer program will execute automatically and earn the profit. The profit taking activities will bring the foreign exchange rate to the equivalent level.