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. These opportunities are rare and traders who take advantage of them usually have advanced computer equipment and/or programs to automate the process.
A trader employing triangular arbitrage, for example, would exchange an amount at one rate (EUR/USD), convert it again (EUR/GBP), and then convert it finally back to the original (USD/GBP), and assuming low transaction costs, net a profit.
- Triangular arbitrage is a form of low-risk profit-making by currency traders that takes advantage of exchange rate discrepancies through algorithmic trades.
- To ensure profits, such trades should be performed quickly and should be large in size.
- Because triangular arbitrage opportunities are regularly exploited, currency markets become more efficient.
Understanding Triangular Arbitrage
This type of arbitrage can result in a "riskless" profit if quoted currency exchange rates do not equal the market's cross-exchange rate. In other words, if two currencies also trade against some third currency, then the exchange rates of all three should be synchronized, otherwise, a profit opportunity exists.
International banks, who make markets in currencies, exploit an inefficiency in the market where one market is overvalued and 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, as an algorithm is created in which a trade is automatically conducted once certain criteria are met. Automated trading platforms allow a trader to set 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 capital, the ability to engage in triangular arbitrage is only feasible using an automated trading platform.
Since the market is essentially a self-correcting entity, 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.
That said, the speed of algorithmic trading platforms and markets can also work against traders. For example, there may be an execution risk in which traders are unable to lock in a profitable price before it moves past them in seconds.
Example of Triangular Arbitrage
As an example, suppose you have $1 million and you are provided with the following exchange rates: EUR/USD = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939.
With these exchange rates there is an arbitrage opportunity:
- Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110
- Sell euros for pounds: €863,100 ÷ 1.4600 = £591,171
- Sell pounds for dollars: £591,171 x 1.6939 = $1,001,384
- Subtract the initial investment from the final amount: $1,001,384 – $1,000,000 = $1,384
From these transactions, you would receive an arbitrage profit of $1,384 (assuming no transaction costs or taxes).