Triangular Arbitrage in Foreign Exchange Markets
Summary
This article explains triangular arbitrage using three currencies and temporarily inconsistent exchange rates. It first illustrates how to compare a directly quoted cross rate with a synthetic rate derived through two other currency pairs. If the three conversions return more of the starting currency than they consume, the cycle appears profitable. The trading outline focuses on comparing a cross pair's market bid and ask with synthetic bid and ask prices calculated from two liquid pairs, then taking the offsetting positions when the discrepancy is large enough.
The example initially assumes away bid-ask spreads and the possibility that displayed quotes cannot be filled. The practical discussion restores transaction costs: the price gap must cover spreads across all legs, and quotes must be sampled at the same time. The article stresses that opportunities may disappear very quickly, so low latency and low fees are central requirements. It offers no measured results and acknowledges that without suitable execution speed and costs, the theoretical arbitrage may not be achievable. Real execution, slippage, and legging risk therefore limit the apparent risk-free nature of the example.
Key ideas
- Triangular arbitrage uses three currency conversions to exploit a temporary inconsistency between direct and synthetic cross rates.
- The strategy compares market bid and ask prices with synthetic prices derived from two other currency pairs.
- A price discrepancy must exceed the trading costs across all three currency legs.
- Quotes need to be observed together, and execution speed matters because discrepancies may be brief.
- The simplified example excludes execution complications, and the article supplies no measured trading results.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.