By Priyamwada Jain
In the world of finance, arbitrage is the practice of taking advantage of a state of imbalance between two or more markets. 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 is called triangular arbitrage. This opportunity for risk-less 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. These opportunities arise when the banks quoted exchange rate is not equal to the markets implicit cross exchange rate.
EXAMPLE:
Bank A: ¥82/$
Bank B: $1.6/
Bank C: ¥128/
An investor has ¥100000000. Can he make any profits through triangular arbitrage?
Well, yes. Let’s see how.
We have first drawn a triangle and placed the exchange rates at every corner of the triangle. Now we need to identify the cross rate and then find the implied cross rate. For this we multiply ¥82/$ and $1.6/. When we multiply these ¥82/$ * $1.6/ the dollars cancel each other and we get ¥131.2/. Here the implied cross rate and the quoted cross rate are different. The quoted cross rate is 128 whereas the implied cross rate is 131.2. Thus, an arbitrage is possible. For this, the investor will sell the yen and then buy the yen again. He will first sell yen for pounds to bank C. Then we give the pounds to bank B and take dollars in return. And then we give the dollars to A and buy yen.
To show the profit amount we can do the following calculations.
The original 100000000 yen are converted to euros by 100000000/128=781250
These euros are then converted to dollars by 781250*1.6=$1250000
These dollars are then again converted to yen by 1250000*82=¥102500000
Thus a profit of 102500000-100000000=¥2500000 is made.
So, we can see that currency rates can be used for arbitrage. However, the profit will occur only when the quoted cross rate and implied cross rate are different in the market. This scenario rarely occurs in the ForEx market; even if it does, not many people are able to identify it. Only experts can identify this. A recent study examining exchange rate data provided by HSBC Bank for the Japanese yen (JPY) and the Swiss franc (CHF) found that although a limited number of arbitrage opportunities appeared to exist for as many as 100 seconds, 95% of them lasted for 5 seconds or less, and 60% lasted for 1 second or less. Further, most arbitrage opportunities were found to have small magnitudes, with 94% of JPY and CHF opportunities existing at a difference of 1 basis point, which translates into a potential arbitrage profit of $100 USD per $1 million USD transacted.
Thus, triangular arbitrage opportunities do exist in the market but a keen eye is needed to identify it and fast moves are needed to take advantage of the situation.
Presently pursuing BCom( Hons) from the Shri Ram College Of Commerce, the author has successfully completed her 1st year. She aspires to do an MBA in the field of Finance. Has worked with Ernst and Young in the past and is constantly associated with the Rotary Club. She can be contacted at jainpriyamvada@gmail.com