Arbitrage trade

 Arbitrage is the simultaneous purchase and sale of an asset in different

markets to exploit tiny differences in their prices.
 Arbitrage trades are made in stocks, commodities, and currencies.
 Arbitrage takes advantage of the inevitable inefficiencies in markets.
 By exploiting market inefficiencies, however, the act of arbitraging brings
markets closer to efficiency.

A trickier example can be found in currencies markets using triangular arbitrage.

In this case, the trader converts one currency to another, converts that second
currency to a third bank, and finally converts the third currency back to the
original currency.

Suppose you have $1 million and you are provided with the following exchange
rates: USD/EUR = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939.

With these exchange rates, there is an arbitrage opportunity:

1. Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110

2. Sell euros for pounds: €863,100 ÷ 1.4600 = £591,171
3. Sell pounds for dollars: £591,171 × 1.6939 = $1,001,384
4. Subtract the initial investment from the final amount: $1,001,384 –
$1,000,000 = $1,384

From these transactions, you would receive an arbitrage profit of $1,384

(assuming no transaction costs or taxes).
Example of a Triangular Arbitrage Opportunity

Sam is an FX trader with $1 million on hand. He detects the following exchange

rates:

Using the cross-rate formula, Sam determines that the €/£ rate is undervalued. The
cross-rate for the pair must be equal:

€/£ = 0.8678 x 1.5028 = 1.3041

Triangular arbitrage can be applied to the three currencies – the US dollar, the
euro, and the pound. To execute the triangular arbitrage opportunity, Sam should
perform the following transactions:

1. Sell dollars for euros: $1,000,000 x 0.8678 = €867,800

2. Sell euros for pounds: €867,800 / 1.3021 = £666,461.87
3. Sell pounds for dollars: £666,461.87 x 1.5028 = $1,001,558.90

By utilizing the discrepancies in the price quotations of the three currencies, Sam
managed to turn his initial $1,000,000 into $1,001,558.90, with a profit of
$1,558.90. Note, that due to the small price discrepancy (only 0.002), even the use
of a substantially large capital resulted in relatively small profits. In our simplified
example, we did not account for transaction costs. Therefore, in real life, the profit
would be even smaller.