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John Shandy` (talk | contribs) m →Mechanics of triangular arbitrage: copyedit |
John Shandy` (talk | contribs) m →Mechanics of triangular arbitrage: copyedit |
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Some international banks serve as [[market maker]]s between currencies by narrowing their [[bid-offer spread|bid-ask spread]] more than the bid-ask spread of the implicit cross exchange rate. However, the bid and ask prices of the implicit cross exchange rate naturally discipline market makers. When banks' quoted exchange rates move out of alignment with cross exchange rates, any banks or traders who detect the discrepancy have an opportunity to earn arbitrage profits via a triangular arbitrage strategy.<ref name="Eun & Resnick 2011" /> To execute a triangular arbitrage trading strategy, a bank would calculate cross exchange rates and compare them with exchange rates quoted by other banks to identify a pricing discrepancy.
For example, [[Citibank]] detects that [[Deutsche Bank]] is quoting dollars at a [[bid price]] of 0.8171 €/$, and that [[Barclays]] is quoting pounds at a bid price of 1.4650 $/£ (Deutsche Bank and Barclays are in other words willing to buy those currencies at those prices). Citibank itself is quoting the same prices for these two exchange rates. A trader at Citibank then sees that [[Crédit Agricole]] is quoting pounds at an [[ask price]] of 1.1910 €/£ (in other words it is willing to sell pounds at that price). While the quoted market cross exchange rate is 1.1910 €/£, Citibank's trader realizes that the implicit cross exchange rate is 1.1971 €/£ (by calculating 1.4650 × 0.8171 = 1.1971), meaning that Crédit Agricole has narrowed its bid-ask spread to serve as a market maker between the euro and the pound. Although the market suggests the implicit cross exchange rate should be 1.1971 euros per pound, Crédit Agricole is selling pounds at a lower price of 1.1910 euros. Citibank's trader can hastily exercise triangular arbitrage by exchanging dollars for euros with Deutsche Bank, then exchanging euros for pounds with Crédit Agricole, and finally exchanging pounds for dollars with Barclays. The following steps illustrate the triangular arbitrage transaction.<ref name="Eun & Resnick 2011" />
#Citibank sells $5,000,000 to Deutsche Bank for euros, receiving €4,085,500. ($5,000,000 × 0.8171 €/$ = €4,085,500)
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