Triangular Arbitrage Example

Triangular Arbitrage

• An arbitrage is a zero-risk, zero-investment strategy that guarantees a profit.
• Triangular arbitrage involves trading among three currencies when the quoted cross-exchange rate is not in alignment with the implied cross-exchange rate.
• The purpose of triangular arbitrage is to earn an arbitrage profit by trading out of a currency into a second currency, then trading it for a third currency, which is in turn traded back into the original currency.

Triangular Arbitrage Example

• Given exchange rates: $1.0785/SFr (Credit Suisse), ¥115.11/$ (JPMorgan), ¥125.10/SFr (Mizuho)
• Implied ¥/SFr rate: ¥124.15/SFr (based on dollar exchange rates from Credit Suisse and JPMorgan)
• Arbitrage opportunity: Sell SFr to Mizuho for ¥, buy ¥ with $, sell ¥ for $, and earn an arbitrage profit.

FX Market Structure

• The spot FX market has a two-tier structure:
  • Interbank/Wholesale market (> 90% of trading volume)
    • Large commercial and investment banks, securities houses, non-bank dealers, and FX brokers
  • Client/Retail market (< 10% of trading volume)
    • Market participants include MNCs, money managers, and private speculators

Market Microstructure

• Bid-ask spreads in the spot FX market increase with FX exchange rate volatility and decrease with dealer competition.
• Bid-ask spreads have a prolonged U-shape and are narrowest when London and NY markets are open.
• Trading volume and exchange rate volatility are both M-shaped, with peaks at London and NY openings.
• Significant variation in liquidity across exchange rates and over time.

Foreign Exchange Market Participants

• Interbank market is made up of a network of correspondent banking relationships.
• Correspondent bank account network facilitates the efficient functioning of the FX market.
• International banks communicate using SWIFT, and CHIPS serves as a clearinghouse for interbank settlement.

A quiz on identifying arbitrage opportunities in foreign exchange rates, using quoted and implied cross-rates.