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Triangular Arbitrage in Forex Trading

The cross rate implied by the bid quotes is: QAR/£ = QAR/€ x €/£ = 3.95 x 1.19 = 4.71 Since the bid quote for QAR/£ from Doha Bank is 4.90, there is an arbitrage opportunity. The trader can do the following: 1) Sell 1 million QAR to QNB and get €253,407 (1 million / 3.95) 2) Sell the €253,407 to Commercial Bank and get £212,586 (253,407 x 1.19) 3) Sell the £212,586 to Doha Bank and get Q

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86 views6 pages

Triangular Arbitrage in Forex Trading

The cross rate implied by the bid quotes is: QAR/£ = QAR/€ x €/£ = 3.95 x 1.19 = 4.71 Since the bid quote for QAR/£ from Doha Bank is 4.90, there is an arbitrage opportunity. The trader can do the following: 1) Sell 1 million QAR to QNB and get €253,407 (1 million / 3.95) 2) Sell the €253,407 to Commercial Bank and get £212,586 (253,407 x 1.19) 3) Sell the £212,586 to Doha Bank and get Q

Uploaded by

Amiko Gogitidze
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70-398 International Finance – Spring 2023

riangular Arbitrage Example

Suppose David Sylvian, a trader at the foreign exchange desk of Goldman Sachs in London, observes the
following exchange rates of the euro relative to the pound and the dollar and the dollar relative to the pound:

• EUR1.1555/GBP or GBP0.86543/EUR
• EUR0.76388/USD or USD1.3091/EUR
• USD1.5386/GBP or GBP0.64994/USD

The revenue in pounds of selling EUR10,000,000 at the direct cross-rate would be

EUR10,000,000 × (GBP0.86543/EUR) = GBP8,654,300

Because the exchange rate of dollars per pound is (USD1.5386/GBP), David would be able to sell
GBP8,654,300 for dollars to get

GBP8,654,300 × (USD1.5386/GBP) = USD13,315,506

Then, because the exchange rate of euros per dollar is EUR0.76388/USD, he would sell the
USD13,315,506 for euros to get

USD13,315,506 × (EUR0.76388/USD) = EUR10,171,449

If David had truly been able to make these transactions simultaneously, he would have made

EUR10,171,449 – EUR10,000,000 = EUR171,449

for an instantaneous rate of return of 1.71% = (EUR171,449/EUR10,000,000)

This example demonstrates how triangular arbitrage provides an instantaneous opportunity for profit if
these were the actual market quotes. The data for the dollar exchange rates is, in fact, from quotes from the
Wall Street Journal. We can use them to calculate the true cross-rate of EUR/GBP using the dollar as an
intermediary currency:

(EUR0.76388/USD) × (USD1.5386/GBP) = EUR1.1753/GBP

This is 1.71% larger than the rate quoted in the example above; EUR1.1555/GBP.

Traders in the foreign exchange market will quickly capitalize on such a situation, figuring out which
direction to move around the triangle in order to make a profit. David Sylvian made money by going in the
clockwise direction; he first sold euros for pounds, then obtained dollars with the pounds, and finally euros
with dollars.

He knew this was the way to go because he compared the direct revenue in pounds (GBP0.86543/EUR)
with the implied one we computed using the dollar:

1/[EUR1.1753/GBP] = GBP0.85085/EUR
Three things are important to note about triangular arbitrage.

First, to be an effective arbitrage, the transactions must all be conducted simultaneously. Because it is not
physically possible to do all three transactions simultaneously, there is some risk involved in any attempted
triangular arbitrage because prices might change between transactions.

Second, as traders place orders to conduct the arbitrage in this example, market forces are created that bring
the quoted direct cross-rate back into alignment with the indirect cross-rate—the rate we calculated. In our
example, we have

GBP0.86543/EUR > GBP0.64994/USD × USD1.3091/EUR

As traders sell euros for pounds to conduct the arbitrage, the supply of euros (that is, the demand for pounds)
increases in this market, which tends to drive down the GBP/EUR rate. Selling pounds for dollars tends to
drive up the GBP/USD rate because it increases the supply of pounds (demand for dollars) in this market,
and selling dollars for euros tends to drive up the USD/EUR rate because it increases the supply of dollars
(that is, the demand for euros) in this market. Eventually, the two sides of the equation will once again equal
one another. At that point, arbitrage profits will no longer be possible.

The third point is that the arbitrage need not start by using the euro to purchase pounds. The triangular
arbitrage would be profitable starting from any of the currencies, as long as we trade in the same direction
and go completely around the triangle.
Yen–Dollar and Dollar–Yen Bid and Ask Rates

A yen–dollar bank trader would quote a bid price of yen per dollar at which she is willing to buy dollars
in exchange for yen of, say, ¥110.25/$. The trader would then quote a higher ask price of yen per dollar
(also called the offer price) at which she is willing to sell dollars for yen, say, at an exchange rate of
¥110.30/$. In this latter transaction, the trader can be said to be offering dollars, the base currency in the
denominator, to the market, and she is willing to accept yen in return.

What are the dollar per yen bid and ask rates?

The bid rate is the dollar price of yen at which the bank trader is willing to buy yen with dollars from the
market, and the ask rate is the dollar price at which the bank trader is willing to sell yen for dollars to the
market.

Since buying yen from the market is equivalent to selling dollars to the market, the dollar per yen bid rate
must be the reciprocal of the yen per dollar ask rate,

[1/¥110.30/$]ask = ($0.009066/¥)bid.

Similarly, selling yen to the market is the equivalent of buying dollars from the market, thus

[1/(¥110.25/$)bid] = ($0.009070/¥)ask
Taking Advantage of a Triangular Arbitrage Opportunity with Bid-Ask

Example 1

Assume the cross-rate trader at Deutsche Bank notices that Crédit Lyonnais is buying dollars at Sb(€/$) =
.8833 the same as Deutsche Bank’s bid price. Similarly, he observes that Barclays is buying British pounds
at Sb($/£) = 1.4397, also the same as Deutsche Bank. He next finds that Crédit Agricole is making a direct
market between the euro and the pound, with a current ask price of Sa(€/£) = 1.2712.

Cross-rate implies that the €/£ bid price should be no lower than Sb(€/£) = 1.4397 × .8833 = 1.2717. Yet
Crédit Agricole is offering to sell British pounds at a rate of only 1.2712!

A triangular arbitrage profit is available if the Deutsche Bank traders are quick enough. A sale of $5,000,000
to Crédit Lyonnais for euros will yield €4,416,500 = $5,000,000 × .8833. The €4,416,500 will be resold to
Crédit Agricole for £3,474,276 = €4,416,500/1.2712. Likewise, the British pounds will be resold to
Barclays for $5,001,915= £3,474,276 × 1.4397, yielding an arbitrage profit of $1,915. See the diagram
below which presents a summary of this triangular arbitrage example.

Obviously, Crédit Agricole must raise its asking price above €1.2712/£1.00. Assume the cross-exchange
rates of €/£ bid-ask prices of €1.2717 − €1.2727. These prices imply that Crédit Agricole can deal inside
the spread and sell for less than €1.2727, but not less than €1.2717. An ask price of €1.2720, for example,
would eliminate profit to the arbitrageur. At that price, the €4,416,500 would be resold for £3,474,091 =
€4,416,500/1.2720, which in turn would yield only $4,998,769 = £3,472,091 × 1.4397 or a loss of $1,231.

In today’s “high-tech” FX market, many FX trading rooms around the world have developed in-house
software that receives a digital feed of real-time FX prices from the ICAP Spot electronic broking system
to explore for triangular arbitrage opportunities. Just a few years ago, prior to the development of
computerized dealing systems, the FX market was considered too efficient to yield triangular arbitrage
profits!
Example 2

Assume the cross-rate trader at QInvest has QAR 1 million to trade currencies and notices the following
spot quotes. Is there an arbitrage opportunity? If so, how can he take advantage of it?

QNB S b (QAR/€) = 3.95 S a (QAR/€) = 3.98


Commercial Bank S b (€/£) = 1.19 S a (€/£) = 1.22
Doha Bank S b (Q AR /£) = 4.90 S a (Q AR /£) = 4.95

Common questions

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Foreign exchange desks operationally leverage arbitrage opportunities by constantly monitoring multiple currency quotes and swiftly executing trades to exploit any discrepancies. Factors they must consider include the precision of real-time data for quote comparisons, transaction costs, and the time it takes to execute the trades as this impacts potential profit. They also need to stay aware of volume limitations, liquidity in the market, technological system capabilities, and regulatory constraints. Effective execution relies on the ability to capitalize on momentary market inefficiencies before they are corrected by market forces .

Arbitrageurs can utilize cross-exchange bid-ask price spreads to detect discrepancies in market pricing where profits can be realized by arbitraging between bid and ask spreads. For example, if the direct exchange rate's ask price is lower than the implied cross-rate bid price calculated via another exchange route, an opportunity arises. By purchasing currency at the lower ask price and selling at the higher implied bid price, traders realize gains. Identifying such spreads requires careful analysis of cross-rate implications, quickly executing trade sequences, and considering trader fees to ensure net profitability .

Triangular arbitrage takes advantage of discrepancies in currency exchange rates by exploiting differing quotes when converting between three currencies. For instance, David Sylvian was able to generate a profit by selling EUR10,000,000 using an initial direct cross-rate to get GBP, then converting GBP to USD, and finally USD back to EUR, ending up with EUR10,171,449. The profit arises from the rate disparities as the computed EUR/GBP cross-rate using a dollar intermediary was 1.71% higher than the quoted rate. Therefore, a profit of EUR171,449 analogous to a 1.71% return on investment was possible if the transactions were executed simultaneously .

Arbitrage plays a crucial role in promoting market efficiency in foreign exchange markets by ensuring currency rates accurately reflect available market information. Profitable arbitrage opportunities arise from temporary inefficiencies, such as discrepancies in cross-rates, which are corrected as traders exploit these opportunities. This continuous process forces the exchange rates to realign with their intrinsic values, ensuring that prices reflect underlying economic indicators and factors. Hence, arbitrage acts as a self-correcting mechanism, fostering a more stable and efficient market where rate disparities are minimized .

Arbitrage-related market dynamics balance currency rates through the alteration of supply and demand. As traders execute arbitrage transactions, they affect the supply and demand for the currencies involved. For example, selling euros for pounds increases the demand for pounds, potentially reducing the value of euros relative to the pound. Selling those pounds for dollars then increases dollar demand. Finally, selling dollars for euros increases euro demand relative to the dollar. These activities correct the discrepancies, aligning quoted rates with the calculated cross-rates over time, ensuring the market returns to equilibrium where arbitrage opportunities diminish .

Non-simultaneous transactions introduce significant risks in attempts to execute triangular arbitrage, including the possibility of adverse rate changes that can negate potential profits or result in losses. Since the FX market is dynamic and rates can fluctuate quickly due to numerous trading activities, any delay between completing transaction legs increases exposure to price swings. This sensitivity requires traders to minimize execution latency and market exposure to maintain potential profitability. Successful arbitrage in such scenarios often demands high-frequency trading capabilities to approach simultaneous transaction execution .

When a trader encounters potential arbitrage opportunities across bid-ask spreads, the strategic approach involves swiftly executing the trades before the spreads adjust or diminish. The trader must first confirm that the implied cross-rate from available bid and ask prices results in a profitable arbitrage loop. As illustrated, if the cross-rate suggest a potential profit due to significant spread differences, the trader should quickly execute trades to exploit these differences. However, traders must consider transaction costs and immediacy of execution, as rapid market responses to their trading actions may reduce potential profits or even render the arbitrage unprofitable .

Bid and ask rates determine the prices at which traders are willing to buy or sell currencies, influencing the profitability of triangular arbitrage. For instance, a Deutsche Bank cross-rate trader could profit because Crédit Agricole's ask price for direct euro-pound exchange was lower than the implied cross-rate. This discrepancy allows for exploiting the rate spread to achieve arbitrage profit. If Crédit Agricole adjusted the asking price within the expected spread, the profit could vanish or turn into a loss. Therefore, knowing bid-ask spreads helps traders identify when the arbitrage triangle is favorable for profitable trades .

To effectively achieve triangular arbitrage, transactions must be conducted simultaneously to lock in the profit from rate discrepancies before market forces correct these discrepancies. The risk involved is that prices might change between transactions since executing all legs of the trade instantaneously is not physically feasible. As orders are placed, market supply and demand dynamics adjust the rates, aligning the quoted and calculated cross-rates, thereby dissolving the arbitrage opportunity. Consequently, any delay introduces risk and potential for losses if the rates change unfavorably during execution .

Real-time FX market technology significantly enhances the detection and execution of triangular arbitrage by providing immediate data on currency rates and allowing instantaneous trade placement. In today's "high-tech" FX market, computerized dealing systems, such as the ICAP Spot electronic broking system, provide real-time digital feeds of FX prices. These systems enable traders to swiftly identify and capitalize on rate discrepancies before market forces eliminate arbitrage opportunities, significantly reducing both the time and risk associated with manual calculations and execution delays. Consequently, these technological advancements make the market less susceptible to inefficient pricing .

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