FOREIGN EXCHANGE ARBITRAGE

Introduction
This is the exploitation of exchange rate differentials or inconsistencies to make a risk
less profit. An important characteristic of the arbitrage is that it has the effect of
eliminating the differentials, which give rise to profit opportunities.

For example, suppose that, sterling exchange rate quoted in London is GBP1=US$2
while in New York it is GBP1=US$1.95. Assuming no transaction cost, it would be
profitable to sell sterling in London and simultaneously buy sterling in New York. A sale
of GBP1000 in London, for example would yield US$ 2000. These dollars could then be
exchanged for $2000/1.95 = GBP1025.64 in New York, making a risk less profit of
GBP25.64. Such purchases and sales however will lead to an:

a) Appreciation of sterling in New York

b) Depreciation of sterling in London

Triangular Arbitrage
This is 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.
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.

Simply, triangular arbitrage process involves the following steps: -

1. Acquire the domestic currency

2. Exchange the domestic currency for the common currency
3. Convert the obtained units of the common currency into the second (other)
currency
4. Convert the obtained units of the other currency into the domestic currency

Given the exchange rate between the dollar and the British Pound, S $/£, and the exchange
rate between the dollar and the German Mark, S $/DM, the exchange rate between the
German Mark and the British Pound, SDM/£ , should be:-

S$/£
S DM / £ =
S $ / DM

1
For example, if the exchange rate between the dollar and the British Pound is $1.50/£1
and the exchange rate between the dollar and the German Mark is $.75/DM1, the
exchange rate between the German Mark and the British Pound is: -

$ 1.50/ £ 1
S DM / £ = = DM2/£1
$ 0.75/ DM 1

If the exchange rate between the German Mark and the British Pound were either greater
or less than DM2/£1, then a triangular arbitrage opportunity will be available. For
example, suppose that the Mark/Pound exchange rate were DM2.1/£1. Then a trader with
two German Marks would (1) exchange them for $1.50 (2 x $.75/DM1). The $1.5 would
then (2) be exchanged for one British Pound, which would then (3) be used to purchase
DM 2.1, which is greater than the number of German Marks that the trader started with.

Illustration 1
You are given the following exchange rates
Dutch guilders per US dollar fl 1.9025/US$
Canadian dollars per US dollar C$ 1.2646/US$
Dutch guilders per Canadian dollar fl 1.5214/C$

Questions
a) Is there any opportunity for arbitration?
b) How can a Dutch trader with fl1,000,000 use that amount to benefit from the inter
market arbitration?
c) What will be the profit or loss for a Dutch trader?

Solution
(a) This can be done by finding a cross rate of Dutch guilders against Canadian dollar and
compare it with the actual quotation. If the cross rate is not the same as actual quotation,
then the arbitrage opportunity exists

If the cross rate <actual quotation = opportunity for profit

If the cross rate > actual quotation = opportunity for loss

Hence,
Cross rate will be fl 1.9025/US$ = fl 1.5214/C$
C$ 1.2646/US$

Since this is not the same as actual quotation, then there is opportunity for inter market
arbitration

(b) A Dutch trader will do the following in order to benefit from inter market arbitration

2
  Sell fl 1,000,000 in the spot market at fl 1.9025/US$ and get US$ 525,624
 Simultaneously sell the proceed US$525,624 in United States at C$1.2646/US$
and get C$ 664,704
 Resell Canadian dollar of C$664,704 at the rate of fl1.5214/C$, hence obtain fl
1,011,281

(c) The profit from arbitration is fl1, 011,281 – fl 1,000,000 = fl 11,281.

Illustration 2.
Suppose you have $1 million and you are provided with the following exchange rates:
EUR/USD = 0.8631, EUR/GBP = 1.4600 and USD/GBP = 1.6939

With these exchange rates, is there an arbitrage opportunity?

Sell dollars for euros: $1 million x 0.8631 = 863,100 euros

Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds
Sell pounds for dollars: 591,164.40 x 1.6939 = $1,001,373 dollars
$1,001,373 - $1,000,000 = $1,373

From these transactions, you would receive an arbitrage profit of $1,373 (assuming no
transaction costs or taxes).