International Arbitrage

Locational Arbitrage
Triangular Arbitrage
 International Arbitrage
• Arbitrage is a process of capitalizing on a discrepancy in
quoted prices by making a riskless profit.
• Motive of trader is making profit from the arbitrage
opportunity.
• The arbitrage opportunity may exist only for a short while
• Arbitrage process will cause prices to realign and opportunity
will disappear
• Three forms of arbitrage:
 Locational arbitrage
 Triangular arbitrage
 Covered interest arbitrage
 Inter-market / Locational Arbitrage
in Spot Market
Capitalizes on discrepancies in exchange rates for the
same pair of currencies across locations

Value of £ Value of £
quoted in quoted in
Dollars by a US Dollars by a
bank British bank
 Locational Arbitrage in Spot Market
• Locational Arbitrage is the process of buying a currency at
the location where it is priced cheap and immediately
selling it at another location where it is priced higher.
• Gains from locational arbitrage are based on the amount
of money used and the size of the discrepancy.
• Realignment due to locational arbitrage drives prices to
adjust in different locations so as to eliminate
discrepancies.
Currency Quotes and Locational Arbitrage
NORTH BANK SOUTH
BANK
BID ASK BID ASK
NZ$ $0.635 $0.640 NZ$ $0.645 $0.650

• Assume you have $10000 to invest in this arbitrage

opportunity
• Good Strategy: Buy Cheap and sell at higher price
• If Bid Price of one Bank is higher than the Ask Price of
another for the same currency, there is an opportunity
for locational arbitrage (simultaneous buy and sell)
• So, if Bid1>Ask2, there is an arbitrage opportunity
• Before we proceed, understand what is the base
currency in these quotes
 Locational Arbitrage

NORTH BANK SOUTH BANK

BID ASK BID ASK
NZ$ $0.635 $0.640 NZ$ $0.645 $0.650

 NZ$=$÷ NZ$
$ NZ$ $  $=NZ$ ×

$10000
Arbitrager
• The Arbitrager will get NZ$ 15625 from North Bank and
• can sell them to South Bank for $ 10078.125 and
• make a profit of $78.125
 Example: Locational Arbitrage
Given the following quotes, find out if there is any
arbitrage opportunity. If yes, suggest the profitable
trading strategy, given that you have $10,000 to invest

CITIBANK, NY Barkleys Bank, London

Base BID ASK Base BID ASK
Euro $1.1064 $1.1067 Euro $1.1072 $1.1077
 Solution #3.8: Locational Arbitrage

CITIBANK, NY Barkleys Bank, London

Base BID ASK Base BID ASK
Euro $1.1064 $1.1067 Euro $1.1072 $1.1077

 €=$÷  $=$ ×
€ $
$ €

$1000000
Arbitrager
• The Corporate Treasury will get €903587 from Citibank
• It can sell Euros to Barkleys Bank for $ 1000452 and
• make a profit of $452
 Cross Rates

  ¥   $   ¥
$ € €
 Cross Rates
• Many currency pairs are only inactively traded and there
rates may not be readily available in the market.
• In such a case, the exchange rate for that pair is determined
through their relationship to a widely traded third currency
(cross rate), with which each of the two currency are paired
and traded
• For example a Mexican importer needs Japanese Yen to pay
for purchases in Tokyo.
• MXP/Yen is inactively traded and quotes are not easily
available. But, both the Mexican Peso and the Japanese Yen
are commonly quoted against the US Dollars
Japanese yen JPY118.79/USD
Mexican peso MXN14.8638/USD
 Example: Cross Rates
•
• The following quotes are available:
 
• JPY118.79/USD
• MXN14.8638/USD
• Putting it differently
• = 118.79 and =14.8638
  𝐽𝑃𝑌  𝑀𝑋𝑁   𝐽𝑃𝑌
𝑈𝑆𝐷 ? 𝑈𝑆𝐷 =
𝑀𝑋𝑁

  𝐽𝑃𝑌  𝑀𝑋𝑁   𝐽𝑃𝑌  118.79

𝑈𝑆𝐷 ÷ 𝑈𝑆𝐷 =
𝑀𝑋𝑁 =
14.8638
=JPY7.9919/MXN
Cross rates can also be used to check on opportunities for inter-
market arbitrage.
 Example: Cross Rates (Try again)
• Assume $/¥ rate is not quoted in a specific market
• But we have S($/€) = 1.50
– i.e. $1.50 = €1.00
• and also S(¥/€) = 50
– i.e. €1.00 = ¥50
• What must the $/¥ cross rate be?

  $   ¥   $
€ ? € =
¥

  $   ¥   $  𝟏 . 𝟓𝟎
€ ÷ € =
¥ = 𝟓𝟎
=$/ ¥ = 0.0300
 Triangular Arbitrage

Value of £
quoted in
Euro

Value of £ Value of $
quoted in quoted in
Dollars Euro
 Cross Rates and quoted Rates:
Opportunity for Arbitrage
• Cross Rates are implied quotes as they are not offered in the
market by any trader.
• A given currency pair my have a quoted rated offered by
trader(s)
• What happens when in two different markets, the cross rates
and quoted rates differ.
• In such a situation, there is an opportunity for making profit
by trading in the different currencies in different market and
exploit the difference as profit.
• This is also called triangular arbitrage.
 Triangular Arbitrage
• Triangular Arbitrage is an opportunity for currency transactions in the spot
market to profit from discrepancies in the cross exchange rates between
two currencies.
• This type of arbitrage is offers riskless profit that occurs when a quoted
exchange rate does not equal the market's cross-exchange rate.
• However, Transaction costs (bid/ask spread) can reduce or even eliminate
the gains from triangular arbitrage.
• International banks, who make markets in currencies, exploit an
inefficiency in the market where one market is overvalued and another is
undervalued.
• Cross rates can be used to check on opportunities for inter-market
arbitrage. Suppose the following exchange rates are quoted:
• However, such and opportunity can exists only for a short while and
arbitrage transactions will change the demand supply dynamics and forcing
the exchange rates back into equilibrium.
 Triangular Arbitrage: An example

• Suppose the following exchange rates are quoted:

• Citibank quotes S($/£)=$1.30
• Barclays Bank quotes S(¥/$)=¥120
• Credit Agricole quotes S(¥/£)=¥165
• Can we make money through inter-market arbitrage?
Value of £
quoted in
$

Value of $ Value of £
quoted in ¥ quoted in ¥
 Solution: Triangular Arbitrage
• Citibank quotes S($/£)=1.30
• Barclays Bank quotes S(¥/$)=120
• Credit Agricole quotes S(¥/£)=165
• First calculate any implied cross rate to see if an arbitrage exists. It pays to
find the cross rate for currencies other than the one you have to invest.
• Implied/ Cross Rate ¥/£ =1.30 X 120 = ¥156 per £
• This price is different from quoted. Thus, opportunity of arbitrage exits
• Credit Agricole ready to buy pound at a higher price i.e. ¥165 per £
• I can sell Pound expensive for Yen to Credit Agricole but you donot have
Pound for which Credit Agricole is giving the quote for Yen
• So, you make a few more transactions; first to buy Pound and then to
sell Pound at higher rate.
 Solution : Triangular Arbitrage

Citibank quotes S($/£)=1.30

Barclays Bank quotes S(¥/$)=120
Credit Agricole quotes S(¥/£)=165 $
Gain
$10576.92 $10000 $576.92

Barclays Bank Citibank

$10000
S(¥/$)=120 S($/£)=1.30
Cross Rate
¥/£ =156
¥1269231 £7692.31

It is because you are ¥ £

selling Pounds at rate
higher than cross rate! Credit Agricole
S(¥/£)=165
 Alternative Strategy
• What if you use alternative route.
• We sell USD to buy Yen and sell Yen to buy Pound to be later
sold to buy USD
• This way, we will have to buy Pound at a higher price
yen/pound=165 which is higher than the cross rate Yen/Pound =
156.
• There will be loss in this transaction
• So, look for low cost purchase and high price sale while deciding
the route in triangular arbitrage
• Also keep in mind that there is transaction cost associated
 Loss if Reverse Path in Triangular Arbitrage

Citibank quotes S($/£)=1.30

Barclays Bank quotes S(¥/$)=120
Credit Agricole quotes S(¥/£)=165 $
Loss
$10000 $9454.55 $545.45

Barclays Bank Citibank

$10000
S(¥/$)=120 S($/£)=1.30
Cross Rate
¥/£ =156
¥1200000 £7272.73

It is because now you are ¥ £

buying Pounds at rate
higher than cross rate! Credit Agricole
S(¥/£)=165
Another Example : Triangular Arbitrage
• Suppose the following exchange rates are quoted:
• Citibank quotes S($/€)=1.3297
• Barclays Bank quotes S($/£)=1.5585
• Dressner Bank quotes S(€/£)=1.1740
• Can you make money through inter-market arbitrage, and
how much money can be made if you have $10000 to
invest?
 Solution: Triangular Arbitrage
• Citibank quotes S($/€)=1.3297
• Barclays Bank quotes S($/£)=1.5585
• Dressner Bank quotes S(€/£)=1.1740
• First calculate any implied cross rate to see if an arbitrage exists. It pays to find the
cross rate for currencies other than the one you have to invest.
• We can find the cross rate for €/£
• Implied/ Cross Rate €/£ =1.5585/1.3297= € 1.1721 per £
• This price is different from quoted. Thus, opportunity of arbitrage exits
• Dressner Bank ready to give more Euros for every pound. So, we sell Pounds to
Dressner Bank at a higher price i.e. Euro 1.1740/£ as compared to the cross rate
Euro per Pound
• But we donot have Pound; we have USD
• So, you make a few more transactions; first to buy Pound and then to sell Pound
at higher rate.
 Solution : Triangular Arbitrage
Citibank quotes S($/€)=1.3297
Barclays Bank quotes S($/£)=1.5585
Dressner Bank quotes S(€/£)=1.1740 $
Gain
$10016.48 $10000 $16.48

Barclays Bank
$10000
Citibank quotes S($/ S($/£)=1.5585
€)=1.3297 Cross Rate
€/£ =1.1721
€7532.88 £6416.43

€ £
It is because you are
selling Pounds at rate Dressner Bank
higher than cross rate!
S(€/£)=1.1740
 Solution : Alternative route to Triangular Arbitrage
Citibank quotes S($/€)=1.3297
Barclays Bank quotes S($/£)=1.5585
Dressner Bank quotes S(€/£)=1.1740 $
Loss
$10000 $9983.55 $16.45

Barclays Bank
$10000
Citibank quotes S($/ S($/£)=1.5585
€)=1.3297 Cross Rate
€/£ =1.1721
€7520.49 £6405.87

€ £

It is because now you are

buying Pounds at rate Dressner Bank
higher than cross rate! S(€/£)=1.1740
 Do Triangular Arbitrage Opportunities
Actually Exist
• As a matter of fact, triangular arbitrage opportunities do
actually exist in the forex trading market.
• However, it is important to note that these opportunities are
very rare and often exist only for a few seconds. Why?
• These arbitrage opportunities will not last forever. Once people
start to engage in these profit taking activities, the market will
correct itself and bring the foreign exchange rate to the
equivalent level.
• Furthermore, with the presence of several high-frequency-
trading (HFT) firms today, which uses advance and complicated
computer programs to execute trades automatically, the time
for the market to correct itself is made a lot faster as compared
to a century ago.
THANKS!