In our arbitrage manifesto: BANKNOTE - Why Bankers Never Lose and Why You Should Not Either. You discovered a little bit about the history of how banks operated, and most importantly you learned what money really is; especially the relationship between currencies and debt.
But today we are going to learn one of the most basic and purest forms of arbitrage, one that deals directly with money: the investment strategy of currency arbitrage.
What is Forex Arbitrage?
Forex arbitrage, also known as currency arbitrage trading is one of the oldest forms of money exchange. One of the ways bankers used to trade the money supply of multiple currencies across different bank branches in order to keep a steady balance of foreign coins on hand; in order to complete any kind of international transaction.
The classical and simplest definition of Forex arbitrage states that in order to have a successful trade, one need to find two different clearing houses (or at least two banks) in order to identify a price discrepancy among them. For example:
|Trade Dollars for Euros at a rate of $1 : €1.35||Trade Dollars for Euros at a rate of $1 : €1.33|
In a case like this a currency arbitrageur will structure the trade as follow:
- First, he will buy Euros at the price of 1.35 per USD and then he will take 1.33 of those EUR and trade them back into dollars; pocketing the small profit of 0.02 Euros or 1.481% every time he executed this order.
However this arbitrage strategy has various important factors:
- The transactions cost, the most critical factor to consider since profit margins are so small. However, like in any other type of investment strategy the power of leverage can help us realize a bigger gain and by basic law of financial market trading the bigger the size of the position the lower the transaction cost per share-units becomes.
This was the old classical approach. But today we no longer transport physical money across countries like the Medici and the Rothschild used to do it. Now we use electronic brokers to trade currencies which significantly lower the transactions cost. However, this gain in efficiency comes with a price because electronic trading makes currencies arbitrage opportunities harder to spot.
In fact under current market conditions, the arbitrage opportunity of a currency pair is almost impossible to find. Money market makers like the big online names have the market cornered with very tight bid and ask spread, for all currencies exchange rates.
Hey now, don’t forget what we have learned about the market’s inefficiencies and the law of one price…
“since market participants are imperfect, so are the markets”
Enhance the cross currency arbitrage opportunity of triangular arbitrage.
What is Triangular Arbitrage?
Triangular arbitrage; also known as three-point arbitrage, is the method in which we can create risk free profits from the difference between exchange rates. This strategy is based on the divergence of values between the currencies itself, not the markets. As arbitrageurs what we intend to do is to exploit the very complex task that brokers houses have to keep; where 3 or more currencies have to trade together in harmony with each other at all times.
In order to make triangular arbitrage impossible online Forex dealers have to keep all currencies on balance.
Triangular Arbitrage deals with only three legs of the trade; say for example the algorithmic formula of a trade between the Canadian dollar, the Japanese yen and British pound will have to look something like this:
Triangular Arbitrage Cross Equation:
CAD/JPY * GBP/CAD – GBP/JPY = 0
How to Triangular Arbitrage
In order for me to explain you how to structure and place a triangular trade, it would be best if we use a practical example. Let’s use the past scenario between the CAD, the JPY and the GBP. But please do not be overwhelmed by the amount of information presented here, because as always I am going to prepare for you a free excel spreadsheet that will automatically do all the calculations. Here we go…
- Take – CAD/JPY trading at $1 : ¥ 100
- GBP/CAD trading at £1 : $2
- and – GBP/JPY trading at £1 : ¥202
In plain English; sell CAD buy GBP, sell GBP buy JPY, then buy CAD sell JPY.
$1 / ¥100 * £1 / $2 – £1 / ¥ 202 = 0.000050
In this hypothetical case and with these exchange rates, your possible profit will be 0.000050 Canadian dollars or 0.005% before taxes and transactions cost.
Note: Exchange rates are not based on actual market quotes.
The Bottom Line
I personally follow the currencies markets since they are a very important part of the investment homework of any well-rounded investor; however I do not trade on them. Currency trading is very speculative in nature and I prefer to focus myself in interest spread arbitrage method that I personally designed and shared with you in the Arbitrageur Investing System.
Plus the individual investor should not be involved in the foreign exchange market; because it’s size and speed. Recall our post about the market’s volume; never compete against the black boxes machines.
Case Study Time
Develop an excel spreadsheet that can calculate the performance of currency arbitrage trade.
What tools do you use to follow the currencies markets?