By Jackie,
Researcher

Topic:
Education

Area of discussion: Finance

Area of discussion: Finance

Chapter:
Foreign exchange – Arbitrage opportunity

*The objectives of this research are to find out how people actually earn money via foreign exchange, how they do that (the steps like what currencies they need to buy and sell), how to make a good use of arbitrage opportunity to earn unlimited profit, how to calculate arbitrage profit (sample questions, examples, and calculations are provided to ease understanding) and the limitation and assumption of arbitrage opportunity in foreign exchange (what conditions must be fulfilled in order for this ‘arbitrage opportunity’ to hold).*

**Introduction**

Well, in
finance, I always heard about “high risk, high return” concept, but this arbitrage
concept is totally different. I was really amazed by its concept: No risk,
unlimited return (profit is infinity). Ideally,
‘arbitrage’ involving a simultaneous transaction to be entered at the same
time, that is, the purchase and sale of currencies at the same time in order to
earn ‘arbitrage profit’ due to differences in currencies price quoted in
different places (markets). It is a trade where profits are made by exploiting
price differences of identical or similar financial instruments, on different
markets or in different forms. Arbitrage exists as a result of market
inefficiencies. The reason why no risk is involved is because transactions are
entered simultaneously. There is no delay in time, as time resembles risk and
uncertainly in finance. Unlimited profits
are possible for an astute (alert and smart) trader by re-entering or repeating
those transactions again and again, until the market become efficient or
equilibrium.

**Triangular arbitrage**

Triangular
arbitrage (also referred to as ‘cross currency arbitrage’ or ‘three-point
arbitrage’) is the act of exploiting an arbitrage opportunity resulting from a
pricing discrepancy among three different currencies in the foreign exchange
market. A triangular arbitrage strategy involves three trades, exchanging the initial
currency for a second, the second currency for a third, and the third currency
for the initial. During the second trade, the arbitrageur locks in a zero-risk
profit from the discrepancy that exists when the market cross exchange rate is
not aligned with the implicit cross exchange rate.

Arbitrage profit for one round trip: A$2,538.

Let’s look
at this example:

Suppose we
observe these banks posting these exchange rates:

— Westpac
quote - A$/€ A$1.2223/€

— Barclays
quote - A$/£ A$1.8410/£

— Deutsche
quote - €/£ €1.5100/£

[One round
trip]

Westpac Bank
uses A$1,000,000 to exchange to pound at Barclays Bank at A$1.8410/£. This will
give Westpac Bank £543,183. This amount is then, exchanged to euro at €1.5100/£
at Deutsche Bank. This will give Westpac Bank €820,206. Finally, this amount is
converted back to Australian dollar at A$1.2223/€ in Westpac Bank itself. This
will give Westpac Back A$1,002,538.

Arbitrage profit for one round trip: A$2,538.

**Condition for arbitrage opportunity:**

It is assumed
that Interest Rate Parity (IRP) did not hold. If IRP holds, then there will be
no more arbitrage opportunity. Besides, transaction costs are normally ignored
during calculation. In reality, transaction costs will lower down the arbitrage
profit. In addition, it is assumed that no capital controls are involved.
Governments sometimes restrict import and export of money through taxes and
outright bans.

**Interest Rate Parity (IRP)**

The ratio
between the risk free interest rates in two different countries is equal to the
ratio between the forward and spot exchange rates. Ideally,
Interest Rate Parity (IRP) is a non-arbitrage condition representing an equilibrium state under which investors will be
indifferent to interest rates available on bank deposits in two countries.

**An illustration when Interest Rate Parity (IRP) holds:**

An illustration when Interest
Rate Parity (IRP) failed to hold:

**Additional readings, related links and references:**

This link
provides a simple definition and few good examples of arbitrage as well as
certain underlying assumptions for arbitrage theory to hold. Good link to view
at for new learners or beginners.

An explanation of what is
arbitrage and how to use it in the forex market to generate quick, safe,
profits.

Step-by-step video tutorial and
guides related to the ‘triangular arbitrage concept’ in currency markets.

Triangular
arbitrage’s definition and calculation is available in this link. Extremely
brief article, but I believe beginners can have a basic understanding about
this concept by viewing this (at a glance).

How to
calculate currency cross rate and triangular arbitrage calculation to find
arbitrage profit is shown in this link.