Triangular Arbitrage
Categories: Trading
For trading purposes, currencies come in pairs. Like pants, or turtle doves. Dollar/euro, euro/pound, pound/dollar, etc. Meanwhile, currencies also trade against each other in multiple combinations simultaneously. So while the dollar is trading against the euro, it is also trading against the pound.
The currency pairs move independent to each other, leading to the possibility that a currency might become (however briefly) more highly valued as part of one pair than as part of another. This state of affairs opens the door the triangular arbitrage.
A trader notices a market inefficiency. The dollar has moved more against the euro than it has against the pound. To take advantage, they cycle around through two currencies to end up back to the first currency again. They turn the dollars into pounds, the pounds into euros, and the euros back into dollars. Move fast enough (before the market inefficiency disappears), and the trader ends up with more dollars than they started with. Triangular arbitrage.
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finance a la shmoop what is arbitrage? not yourbritage or mybitrage but
arbitrage what it's been a while since we conjugated anything around here oh ok [Man talking about arbitrage]
so moving on arbitrage is a riskless trade you make guaranteed profits just
for being on top of things or in the right place at the right time or you're
there when opportunity comes a-knockin think about the stock exchanges in the [Men working in stock exchange]
pre-internet era around the world communication well it was relatively
slow and expensive back then especially when it came to sharing data one [Man talking into olden microphone]
relatively easy arbitrage or riskless trade opportunity that came about was
when stocks traded at one price on the various european exchanges versus the
prices it traded at on the US exchanges like shares of IBM might have been [Share price graph of IBM]
offered for sale at $165 32 cents on the london stock exchange even net of
currency conversion prices remember the Brits were on the pound system but in
the US investors were paying $165 47 cents a share
so an easy 15 cents a share was made all day long in buying the shares of IBM in
London and then just selling him back here in New York well both sides of the
trade were made at the same time it was riskless it was arbitrage and arbitrage
became a whole industry for a while until the capital markets went to work
and spreads tightened as communication got more liquid and people sprayed a [Spreads word becomes narrower]
bunch of wd-40 on information passing around the world and then that 15 cent [15 cents transfers from US to England]
spread from London to New York became more like a penny or a tenth of a penny
or at least close enough of a spread so that it was no longer worth bothering to
try and make a buck or a billion whatever those arbitrageours made in
those days