What is Triangular Arbitrage?

815 reads · Last updated: December 5, 2024

Triangular arbitrage is the result of a discrepancy between three foreign currencies that occurs when the currency's exchange rates do not exactly match up. 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, for example, could make the following series of exchanges—USD to EUR to GBP to USD using the EUR/USD, EUR/GBP, and USD/GDP rates, and (assuming low transaction costs) net a profit.

Definition

Triangular arbitrage refers to the opportunity that arises when the exchange rates of three currencies do not perfectly match. These opportunities are rare and typically require advanced computer equipment and programs to automate the process. Traders profit by executing a series of currency exchanges to exploit the rate discrepancies.

Origin

The concept of triangular arbitrage originated with the development of the foreign exchange market. As globalization and the forex market expanded, traders discovered opportunities to exploit inconsistencies in exchange rates between different currency pairs. With technological advancements, the use of computer programs has made this type of arbitrage more feasible.

Categories and Features

Triangular arbitrage primarily involves trading three currency pairs. Its features include the need for rapid execution to capture fleeting market mismatches and sensitivity to transaction costs. Due to increased market efficiency, these arbitrage opportunities are typically very short-lived.

Case Studies

A typical case involves using the EUR/USD, EUR/GBP, and USD/GBP exchange rates for arbitrage. Suppose the EUR/USD rate is 1.2, EUR/GBP is 0.9, and USD/GBP is 0.75. A trader can exchange 1 USD for 0.8333 EUR, then EUR for 0.75 GBP, and finally GBP back to 1 USD, making a profit. Another case involves a large financial institution using high-frequency trading systems to capture market mismatches instantly for large-scale arbitrage.

Common Issues

Investors may encounter issues such as high transaction costs reducing profits and rapid market changes causing arbitrage opportunities to vanish. A common misconception is that these opportunities frequently occur, whereas they are actually very rare and short-lived.

Suggested for You

Interest Rate Future

An interest rate future is a futures contract with an underlying instrument that pays interest. The contract is an agreement between the buyer and seller for the future delivery of any interest-bearing asset.The interest rate futures contract allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.

Historic Pricing

Historic pricing is a unit pricing method used to calculate the value of an asset using the last valuation point calculated. Historic pricing is used when the value of an asset does not update in real time.

Rational Behavior

Rational behavior refers to a decision-making process that is based on making choices that result in the optimal level of benefit or utility for an individual. The assumption of rational behavior implies that people would rather take actions that benefit them versus actions that are neutral or harm them. Most classical economic theories are based on the assumption that all individuals taking part in an activity are behaving rationally.

Discrete Distribution

A Discrete Distribution, also known as a Discrete Probability Distribution, refers to a probability distribution in statistics and probability theory where the random variable can take on a finite or countably infinite number of specific values. Common examples of discrete distributions include the binomial distribution, Poisson distribution, and geometric distribution. In a discrete distribution, each possible value has an associated probability, and the sum of these probabilities is equal to 1. Discrete distributions are widely used in finance, insurance, engineering, and other fields to describe and analyze the probabilities of discrete events. For instance, the number of times a stock price changes, the number of insurance claims, and similar discrete occurrences can be modeled and analyzed using discrete distributions.

White Elephant

A white elephant is something whose cost of upkeep is not in line with its usefulness or value. From an investmentperspective, the term refers to an asset, property, or business that is so expensive to operate and maintain that it is extremely difficult to actually make a profit from it.White elephants also tend to be illiquid assets, meaning they cannot be easily or quickly exchanged or sold for cash without the seller experiencing a significant loss.

Lehman Formula

The Lehman formula is a compensation formula developed by Lehman Brothers to determine the commission on investment banking or other business brokering services. Lehman Brothers developed the Lehman Formula, also known as the Lehman Scale Formula, in the 1960s while raising capital for corporate clients.