Triangular Arbitrage

The process of converting one currency to another, converting it again to a third currency and, finally, converting it back to the original currency within a short time span. This opportunity for riskless profit arises when the currency's exchange rates do not exactly match up. Triangular arbitrage opportunities do not happen very often and when they do, they only last for a matter of seconds. Traders that take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or programs to automate the process.

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:

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

Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds.

Sell pounds for dollars: 591,164.40 x 1.6939 = $1,001,373 dollars

$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).

Contributed by:

Veena Vishwanathan

Globsyn Business School