What is triangular arbitrage
Triangular arbitrage is the result of a spread between three foreign currencies that occurs when the exchange rates of the currency do not match exactly. 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 would trade an amount at one rate (EUR / USD), convert it back (EUR / GBP) and then eventually convert it back to the original (USD / GBP), and assuming low transaction costs , would make a profit.
Basics of Triangular Arbitration
This type of arbitrage is a risk-free profit that occurs when a quoted exchange rate is not equal to the cross market exchange rate. International banks, which make foreign exchange markets, exploit a market inefficiency where one market is overvalued and another undervalued. The price differences between exchange rates are only a few fractions of a cent, and for this form of arbitrage to be profitable, a trader must exchange a large amount of capital.
Automated trading platforms and triangular arbitrage
Automated trading platforms have streamlined the way trades are executed because an algorithm is created in which a trade is automatically executed 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 trade according to the rules. While automated trading has many advantages, such as the ability to test a set of rules on historical data before risking the capital, the ability to engage in triangular arbitrage is only possible with the help of an automated trading platform. Since the market is essentially an auto-correcting entity, trading takes place at such a rapid pace that an arbitrage opportunity disappears seconds after it arises. An automated trading platform can be set up 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 where traders are unable to lock in a profitable price before it exceeds them within seconds.
Key points to remember
- Triangular arbitrage is a form of profit by currency traders in which they profit from exchange rate spreads through algorithmic transactions.
- To ensure profits, these transactions must be completed quickly and must be large in size.
Example of triangular arbitrage
For example, suppose you have $ 1 million and you have the following exchange rates: EUR / USD = 0.8631, EUR / GBP = 1.4600, and USD / GBP = 1.6939.
With these exchange rates, there is an opportunity for arbitrage:
- Sell ââdollars for euros: $ 1 million x 0.8631 = â¬ 863,100
- Sell ââeuros for books: â¬ 863,100 1.4600 = Â£ 591,164.40
- Sell ââbooks for dollars: Â£ 591,164.40 x 1.6939 = $ 1,001,373
- Subtract the initial investment from the final amount: $ 1,001,373 – $ 1,000,000 = $ 1,373
From these trades, you will receive an arbitrage profit of $ 1,373 (assuming there are no transaction fees or taxes).