What is 'Triangular Arbitrage'

Triangular arbitrage is the result of a discrepancy between three foreign currencies that occurs when the currency's exchange rates do not exactly match up. Triangular arbitrage opportunities are rare and traders that take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or programs to automate the process. The trader would exchange an amount at one rate (EUR/USD), convert it again (EUR/GBP), and then covert it finally back to the original (USD/GBP) and assuming low transaction costs, net a profit.

BREAKING DOWN 'Triangular Arbitrage'

Triangular arbitrage is a riskless profit that occurs when a quoted exchange rate does not equal the market's cross exchange rate. Triangular arbitrage exploits an inefficiency in the market where one market is overvalued and the another is undervalued. Price differences between exchange rates are only fractions of a cent, and in order for this form of arbitrage to be profitable, a trader must trade a large amount of capital.

Automated Trading Platforms and Triangular Arbitrage

Automated trading platforms have streamlined the way trades are executed for an algorithm is created in which a trade is automatically executed once certain criteria is met. Automated trading platforms allow a trader to set specific rules for entering and exiting a trade, and the computer will automatically conduct the trade according to the rules. While there are many benefits to automated trading, such as the ability to test a set of rules on historical data before risking investor's money, the ability to engage in triangular arbitrage is only feasible using an automated trading platform. Since the market is essentially a self-correcting entity, if there ever is an inefficiency, trades happen at such a rapid pace that an arbitrage opportunity vanishes seconds after it appears. An automated trading platform can be set to identify an opportunity and act on it before it disappears.

Example

As an example, suppose you have $1 million and you are provided with the following exchange rates: EUR/USD = 0.8631, EUR/GBP = 1.4600 and USD/GBP = 1.6939.

With these exchange rates there is an arbitrage opportunity:

Step 1. Sell dollars for euros: $1 million x 0.8631 = €863,100

Step 2. Sell euros for pounds: €863,100/1.4600 = £591,164.40

Step 3. Sell pounds for dollars: £591,164.40 x 1.6939 = $1,001,373

Step 4. Subtract the initial investment from the final amount: $1,001,373 - $1,000,000 = $1,373

From these transactions, you would receive an arbitrage profit of $1,373 (assuming no transaction costs or taxes).

RELATED TERMS
  1. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  2. Risk Arbitrage

    A broad definition for three types of arbitrage that contain ...
  3. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage ...
  4. Currency Arbitrage

    A forex strategy in which a currency trader takes advantage of ...
  5. Statistical Arbitrage

    A profit situation arising from pricing inefficiencies between ...
  6. Convertible Arbitrage

    A trading strategy that typically involves taking a long strategy ...
Related Articles
  1. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  2. Trading

    Covered Interest Arbitrage

    Covered interest arbitrage is a trading strategy in which an investor uses a forward currency contract to hedge against exchange rate risk.
  3. Investing

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  4. Investing

    How To Arbitrage Precious Metals

    Here are the fine points, trading tips, suitable securities, and examples for precious metal arbitrage trading.
  5. Trading

    NYIF Instructor Series: Risk Arbitrage

    In this short instructional video Jack Farmer explains what risk arbitrage is outlines three different examples of it.
  6. Investing

    Arbitrage Squeezes Profit From Market Inefficiency

    This influential strategy capitalizes on the relationship between price and liquidity.
  7. Trading

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
  8. Trading

    Understanding Arbitrage Pricing Theory

    Investors use the arbitrage pricing theory to identify an asset that’s incorrectly priced.
  9. Investing

    3 Mutual Funds Focusing on Arbitrage Profits (MERFX, ARBFX)

    Get details on three of the most popular mutual funds for investors interested in arbitrage trading.
RELATED FAQS
  1. What skills should I acquire to take advantage of arbitrage trading?

    Understand what arbitrage trading involves and what the necessary skill set is that a trader must develop in order to master ... Read Answer >>
  2. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of arbitrage trading opportunity is available to individual retail ... Read Answer >>
  3. What are the biggest risks associated with covered interest arbitrage?

    Investing money can be confusing for novice investors. Find out more about covered interest arbitrage and the risks that ... Read Answer >>
  4. How do I use software to make arbitrage trades?

    Understand the meaning of arbitrage trading, and learn how traders employ software programs to detect arbitrage trade opportunities. Read Answer >>
  5. What models should I use to make arbitrage trades?

    Learn about different types of arbitrage models and techniques, and discover why classic arbitrage opportunities are very ... Read Answer >>
  6. How do I use an arbitrage strategy in forex trading?

    Forex arbitrage is a risk-free trading strategy that allows retail forex traders to make a profit with no open currency exposure. ... Read Answer >>
Hot Definitions
  1. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  3. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  4. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  5. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  6. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
Trading Center