What is a Triangular Arbitrage Opportunity?
A triangular arbitrage opportunity is a trading method that exploits the arbitrage chances that exist amongst three currencies in a foreign currency exchange. The arbitrage is performed through the consecutive exchange of one currency to another when there are inconsistencies in the priced quote costs for the given currencies.
When the exchange rate of a currency does not match the cross-exchange rate, a triangular arbitrage opportunity occurs. The rate discrepancies typically develop from scenarios when one market is miscalculated while another is undervalued.
The nature of foreign currency exchange markets limits the price inconsistencies in between various currencies to a couple of cents or perhaps to a portion of a cent. The deals in a triangular arbitrage opportunity include trading large amounts of money.
Often, the deals utilize margin trading to enhance the returns. In addition, a trader must know the deal expenses. It is possible that high transaction costs may erase gains from the rate disparities.
Example of a Triangular Arbitrage Opportunity
Sam is an FX trader with $1 million on hand. He detects the following currency exchange rate:
Using the cross-rate formula, Sam figures out that the EUR/ ₤ rate is underestimated. The cross-rate for the pair must be equal:
EUR/ ₤ = 0.8678 x 1.5028 = 1.3041
Triangular arbitrage can be applied to the three currencies– the US dollar, the euro, and the pound. To execute the triangular arbitrage opportunity, Sam needs to perform the following deals:
Offer dollars for euros: $1,000,000 x 0.8678 = EUR867,800.
Offer euros for pounds: EUR867,800/ 1.3021 = ₤ 666,461.87.
Sell pounds for dollars: ₤ 666,461.87 x 1.5028 = $1,001,558.90.
By utilizing the inconsistencies in the rate quotes of the three currencies, Sam managed to turn his initial $1,000,000 into $1,001,558.90, with a revenue of $1,558.90. Keep in mind, that due to the small cost discrepancy (just 0.002), even using a significantly large capital resulted in fairly little profits. In our simplified example, we did not account for deal expenses. For that reason, in real life, the profit would be even smaller sized.
Triangular Arbitrage Opportunities in the Real Life.
Triangular arbitrage opportunities rarely exist in the real life. This can be explained by the nature of foreign currency exchange markets. Forex markets are extremely competitive with a great deal of gamers, such as individual and institutional traders. The competition in the markets continuously fixes the marketplace inefficiencies and arbitrage chances do not last long.
Nowadays, triangular arbitrage chances are typically exploited by high-frequency traders. Utilizing high-speed algorithms, the traders can rapidly spot mispricing and instantly perform the required deals. However, the strong existence of high-frequency traders makes the markets much more efficient. Thus, the variety of offered arbitrage chances diminish.
In addition, the triangular arbitrage method offers applications in cryptocurrency trading. Cryptocurrency markets and exchanges are still in advancement, and more arbitrage chances exist in such markets relative to the conventional currency markets.
By using the disparities in the rate quotations of the three currencies, Sam managed to turn his preliminary $1,000,000 into $1,001,558.90, with an earnings of $1,558.90. Triangular arbitrage opportunities seldom exist in the real world. The competition in the markets continuously remedies the market inadequacies and arbitrage chances do not last long.
Nowadays, triangular arbitrage chances are often exploited by high-frequency traders. Therefore, the number of available arbitrage chances diminish.
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