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What is triangular arbitrage?


John Naronha

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This form of arbitrage is also called cross-currency or three-point arbitrage, and the strategy involves spotting price discrepancies in three different currencies trading on the FX market. The opportunity arises when the quoted exchange rate of a currency varies from its implied cross exchange rate, leading to one of them to be overpriced and the other underpriced.

At first sight, the strategy may look a little complicated from some of the other arbitrage trades which generally involve only 2-legs, however, once a trader comprehends the actual functioning of the strategy, they will find them pretty straight forward.

The triangular strategy broadly involves three trades-

  1. The primary trade comprises exchanging the first currency for the second.
  2. In the next leg of the trade, the second currency is exchanged for the third.
  3. And finally, in the last leg, the third currency is swapped for the first.

Although triangular arbitrage rarely exists, in the event of such a prospect, the price difference between the exchange rates will tend to differ only by a fraction of a cent, but since trades are implemented on large volumes, profits are compounded.

Illustration-

Consider the following three currency pairs

EUR/USD= 0.8862

EUR/GBP= 1.1544

USD/GBP= 1.3039

Suppose there is a price discrepancy in the three currencies and the arbitrageur is trading on a contract size of $1,000,000, the triangular arbitrage strategy will be carried out in the following steps

  1. Sell US dollars/ buy Euros: $1,000,000 X 0.8862 = €886,200
  2. Next, sell Euros/ buy Sterling: €886,200/ 1.1544 = £767,671.51
  3. Finally, sell Sterling/ buy US dollars: £767,671.51 X $1.3039 = $1,000,966.89

The difference between $1,000,966.89 and $1,000,000 is the arbitrage profit = $966.89

So, in the above illustration, the arbitrageur would have earned riskless profits of $966.89, excluding transaction costs and taxes.

 

Risk-

  • These arbitrage opportunities do not necessarily imply profitability since a small delay in execution can take away the arbitrage advantage.
  • Triangular arbitrage is generally carried out using automated trading systems with set rules for entries and exits, making them an expensive proposition for individual traders.
  • Since FX trading involves employing high leverage, execution errors by automated systems can result in massive losses on the leveraged positions.

 

 

 

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Hello John,

Arbitrage chases profits through the parallel sale and purchase of connected assets during a market imbalance. 
A triangular arbitrage, therefore, maximizes pricing disparities involving three currencies in an exchange. A quote variation enables the participant to purchase from a low-cost exchange and sell where it’s more expensive.
Suppose you have currencies X, Y, and Z, where X is the base and Y and Z the counter currencies. The primary stage entails swapping X for Y. It’s followed by exchanging Y for Z before selling Z for X. The chance to profit from unsteady markets sets triangular arbitrage apart from other methods. It’s also low-risk provided you time your trades.
However, broker delays or failure to top up a leg in the arbitrage hampers execution. Since arbitrageurs adjust price differences themselves, such windows are brief. This therefore calls for monitoring tools to identify the opportunities. These programs may be unavailable or too costly for regular traders. What’s more, exorbitant fees minimize profits or render the strategy a negative expectancy. 
 

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