Triangle arbitrage is the practice of taking advantage of a state of imbalance between three markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices.
An example on triangle arbitrage
Suppose that:
- the exchange rate between the French Franc (FF) and the US dollar ($) in France is FF10.00/US$1
- the exchange rate between the Dutch Mark (DM) and the US dollar ($) is 2.00 DM/US$1 in Frankfort
- the exchange rate between French Franc (FF) and the Dutch Mark (DM) is 4.00 FF per DM.
In this case, the cross rate will be as follows:
(10.00 FF/$1) / (2.00 DM/$1) = 5 FF per DM.
That is to say that the exchange rate between the French Franc and the Dutch Mark will be FF5.0 per DM. Assuming that an investor has $5000 to invest; so according to the rule of "buy low, sell high", he will buy $5000 (10 FF/$1) = 50000 FF. Then, he will use the FF to buy DM.
Buy 50000FF / (4 FF/DM) = 12500 DM , and he will use DM to buy dollars. Finally, he will buy 12500 DM / (2 DM/$1) = $6250 to make $1250 risk-free.
See also
