What’s it: Triangular arbitrage is the simultaneous buying and selling of three different currencies and attempts to exploit inconsistencies between their exchange rates. Profits can arise when the cross rates of the three currencies do not really match.
Say, someone changes rupiah to US dollars. From US dollars, he then converts them to Euros. When he did so, arbitrage arose when he made a profit instead of converting rupiah to euros directly.
In the real world, arbitrage opportunities rarely arise. Foreign exchange (forex) traders usually have sophisticated computer equipment or programs to automate the process. So, it minimizes the profit due to the lag time in transaction processing. Additionally, arbitrage opportunities decrease due to the transaction costs involved.
Basics of triangular arbitrage
Triangular arbitrage is a risk-free benefit when the quoted exchange rates are not the same as the market cross rates. Or in other words, the foreign exchange market is inefficient. Hence, the exchange rate may be overvalued in one market and undervalued in another. In this regard, foreign exchange market participants, such as international banks, exploit such inefficiencies to profit.
The price difference between the exchange rates is tiny. Therefore, for this arbitrage to be feasible, transactions must involve a considerable volume.
Often, transactions use margin trading to amplify returns. Also, a forex trader must know the transaction fees. Potential high transaction costs to wipe out the benefits of price differences.
How triangular arbitrage works
The chances of arbitrage in the forex market are low. However, some forex traders may still get it, especially those actively trading forex (high frequency).
Using high-speed algorithms, they can quickly detect price errors. When they appear on the radar, they immediately make the necessary transactions.
Because they involve multiple players, they devise an algorithm to identify and execute any arbitrage opportunity faster than competitors. When traders make similar efforts, it ultimately increases the speed of trade execution on the forex market. That ultimately leads to a more efficient marketplace and reduced opportunities for future arbitrage.
Triangular arbitrage example
Say, you have IDR 1 billion. Assume the exchange rates for the rupiah, euro, and US dollar are as follows:
- IDR14,019 / USD
- USD1.11 / EUR
- IDR 15,610 / EUR
From this data, you may have the opportunity to get an arbitrage advantage. The trick is:
- First, you buy US dollars with the rupiah you have. Of the IDR1 billion you have, you get USD71,332 = IDR1,000,000,000 / 14,019.
- Then, you sell US dollars for Euros for as much as EUR64,263 = USD71,332 / 1.11.
- Then, you convert your Euros into rupiah. You will get IDR 1,003,143,096 = EUR64,263 x 15,610.
- To calculate the arbitrage profit, you subtract the last conversion result from your initial rupiah currency. IDR1,003,143,096 – IDR1,000,000,000 = IDR3,143,096. So, assuming there are no transaction fees or taxes, you will earn IDR3.14 million in profit.
The reasons for triangular arbitrage arise rarely.
Triangular arbitrage opportunities rarely arise in the real world. The automated platform makes trading even more efficient, reducing arbitrage opportunities. Additionally, transaction fees and taxes can wipe out any advantage of exchange rate inconsistencies in the foreign exchange market.
The forex market is very competitive, with many players, such as individual and institutional traders. Competition diminishes inefficiencies and improves market operation. So, arbitrage opportunities do not last long. It may appear and disappear within a few seconds.
Automated trading platform
The automated trading platform has streamlined the way forex trading is executed. The platform makes use of an algorithm in which trades run automatically when specific criteria are met.
Such platforms make it easier for forex traders to set rules for entering and exiting trades. Then, the computer will automatically make trades according to the orders in the algorithm.
As the market continues to move rapidly and automatically, trades occur so rapidly that arbitrage opportunities disappear seconds after appearing. So, programmers will try to fine-tune algorithms to identify opportunities and act on them before they disappear.