Arbitrage is a trading strategy that converts inefficiencies in the market into profitable opportunities. Traders employ several arbitrage techniques. These include triangular arbitrage, peer-to-peer (P2P) arbitrage, cross-border and arbitrage. All these strategies aim to capitalise on price discrepancies across numerous marketplaces.
Most arbitrage methods involve trading two markets. However, the triangular arbitrage strategy takes advantage of the price difference of three asset classes. This makes it a unique strategy. However, it is not so common. This article explores what is triangular arbitrage, along with its risks.
Table of Contents
What is Arbitrage?
In India, there is a high volume of trading on several exchanges. However, the prices of the asset classes may change due to market inefficiencies and supply and demand differences. For instance, the pricing of a company’s shares varies on the Bombay Stock Exchange and the National Stock Exchange. In such instances, investors believe there is a chance for profit.
The simultaneous purchase and sale of instruments like bonds, currencies, stocks, and commodities in different markets to profit from price differences is called arbitrage. These investors are known as arbitrageurs. They keep on finding price differences. Then, they purchase assets at lower prices from one market and sell them at higher prices in another.
What is Triangular Arbitrage?
Let’s now look at the triangular arbitrage definition. Triangular arbitrage is a strategy to make profits in the foreign exchange market by trading three different currencies.
- One overpriced market and one cheap market often cause such price differences. Three trades are made simultaneously by the trader.
- It involves buying a currency and selling another, using a third one as the base currency.
- An opportunity for arbitrage arises when there are discrepancies between the quoted cross-currency rate and the exchange rate.
At a given point, a currency may be overpriced in relation to a currency. However, it may be undervalued against another. In such instances, one can implement the triangular arbitrage strategy. An investor would trade at the lowest possible transaction costs in triangular arbitrage. He would first convert an amount at one rate (USD/EUR), then at another rate (EUR/INR). Finally, he will again convert it back to the original (INR/USD).
Identifying Opportunities for Triangular Arbitrage
The forex market is a self-correcting system. A large number of traders actively trade large amounts of capital. Traders employ computer programs and closely monitor market action to locate opportunities when differences exist in the stated exchange and cross-currency rates. This helps them to maximise the possibilities of profiting from increasing gaps.
How Triangular Arbitrage Works
There are several phases involved in organising a triangular arbitrate.
- Spotting a triangular arbitrage opportunity is the first step. Traders can implement the strategy when the quoted exchange rate differs from the cross-currency rate.
- The next step is to determine the variance between the implied cross-rates and cross-rates.
- Exchanging the base currency for the other currency if there is a discrepancy between the prices determined in the previous step.
- Trading the second currency for a third.
- The trader makes a net profit in the last steps by converting the third currency back into the original currency and deducting the trading expenses.
Example of Triangular Arbitrage
Let’s take an example to understand triangular arbitrage better. Let’s use the USD, EUR, and INR in a hypothetical scenario:
Suppose the exchange rates in the market are as follows:
- 1 USD = 0.85 EUR
- 1 EUR = 90 INR
- 1 USD = 76 INR
There seems to be a potential arbitrage opportunity:
Step 1: Calculate the implied exchange rate from USD to INR using the EUR as an intermediary currency:
- 1 USD = 0.85 EUR (Given)
- 1 EUR = 90 INR (Given)
- So, 1 USD = 0.85 EUR * 90 INR = 76.5 INR (Implied rate)
Step 2: Compare the implied rate with the actual direct rate (1 USD = 76 INR). In this case, there’s an arbitrage opportunity because the implied rate (76.5 INR) is higher than the actual direct rate (76 INR). To take advantage of this:
- Start with 1 USD.
- Convert it to EUR using the given rate: 1 USD = 0.85 EUR.
- Then, convert the obtained EUR to INR using the second given rate: 1 EUR = 90 INR.
- Finally, compare the resulting amount of INR with the initial 1 USD value exchanged directly to INR.
If the resulting INR is more than the direct exchange of 1 USD to INR, then an arbitrage opportunity exists. Traders can exploit this by making a series of quick transactions to generate risk-free profits until the price discrepancies vanish in the market due to the arbitrage activity. However, keep in mind that such opportunities often close rapidly in real markets due to automated trading and efficient pricing mechanisms.
Risks of Triangular Arbitrage
The following are some of the drawbacks of triangular arbitrage.
- It should be noted that in triangular arbitrage, all three trades (or legs) are carried out simultaneously in a few seconds. This is because an arbitrage opportunity might disappear in a matter of milliseconds in some situations. So, the currency rate difference corrects itself extremely fast. Because of this, there are very few opportunities to make profits like this.
- Theoretically, any arbitrage, including triangular arbitrage, gives profits without any risk. However, a trader runs the risk of suffering enormous losses if they wait too long to execute trades. The exchange rates may correct them in the meantime.
- It’s also important to remember that the price variations among currency rates are quite small. Thus, the trader has to invest a substantial sum of money in order to achieve a large profit.
- The trader has to be informed of all transaction expenses and fees in order to benefit from a trade. A trader shall incur a loss if the earnings cannot cover these expenses. Additionally, knowing the expenses helps traders in choosing to execute a trade or leave it.
Conclusion
Triangular arbitrage, while not widespread, involves capitalising on price variations among three currencies. Traders engage in buying and selling different currencies, utilising a third currency as a pivot. To effectively benefit from triangular arbitrage, traders often rely on sophisticated software. This technology aids in rapidly identifying these opportunities and enables swift execution of transactions within seconds. Opting for a proficient platform like Share India is advisable for efficient trading.
