triangular arbitrage looks to profit from discrepancies among three foreign currencies when their exchange rates across markets don t match up these opportunities are rare and traders usually employ sophisticated programs to automate finding these differences it involves exchanging one currency for a second then trading it for a third and then finally exchanging it back into the original currency 
a trader using triangular arbitrage for example could make a series of exchanges u s dollar usd to euros eur to the british pound gbp to usd using the eur usd eur gbp and usd gbp rates and if the transaction costs are low net a profit understanding triangular arbitragetriangular arbitrage is used in foreign exchange trading to exploit differences in exchange rates across different markets it involves three trades exchanging an initial currency for a second the second currency for a third and finally the third currency back to the initial currency ideally at a profit hence the name triangular exchange rates should synchronize across all currency pairs but because of market inefficiencies they sometimes are not these can be caused by delays in moving market information differing levels of liquidity across markets or rapid changes in market conditions prospects for triangular arbitrage are typically fleeting existing for only a few seconds or less as the market quickly corrects the mispricing therefore automated trading systems capable of executing trades at high speed are used to exploit the momentary difference to be successful arbitrage trades have to offer returns greater than the transaction costs involved including bid ask spreads and trading fees the potential profit must outweigh these costs for the arbitrage to be profitable also triangular arbitrage is more feasible in currency pairs with high liquidity since this reduces the influence of the trade on the market price and minimizes the cost of trading 1in practice triangular arbitrage opportunities are rare and are exploited mainly by institutional traders with sophisticated technology capable of instantaneously identifying and acting on these opportunities automated trading platforms and triangular arbitrageautomated trading platforms have streamlined how trades are executed since an algorithm can be created to trade once specific criteria are met automated trading platforms allow a trader to set rules for entering and exiting a trade and the computer will automatically conduct the trade while automated trading has many benefits such as the ability to test potential rules on historical data before risking capital engaging in triangular arbitrage is only feasible using an automated trading platform since the market is thought to be self correcting trades happen so rapidly that an arbitrage opportunity can vanish within seconds of appearing 1the speed of algorithmic trading platforms and markets can also work against traders for example traders may not be able to lock in a profitable price before it moves past their desired position in less than a second causing a loss example of triangular arbitragesuppose we re working with three currencies usd eur and gbp the key to triangular arbitrage is exploiting discrepancies in the currency exchange rates let s say the current market exchange rates are as follows these currency rates mean that 1 usd equals 0 85 eur 1 eur equals 0 70 gbp and 1 gbp equals 1 50 usd to determine if there s an arbitrage opportunity the implied usd gbp exchange rate needs to be calculated and compared with the actual usd gbp exchange rate the implied rate can be found by multiplying the usd eur and eur gbp rates this is done as follows based on the above 1 usd should be exchangeable for 0 595 gbp for an arbitrage opportunity the actual exchange rate for gbp usd is 2 00 which is equal to a usd gbp rate of 1 2 00 0 5 this is lower than the implied rate of 0 595 thus there is the potential for triangular arbitrage let s say the trader has 100 000 usd the execution of the trades would be as follows 100 000 x 0 85 85 000 eur85 000 x 0 70 59 500 gbp59 500 x 2 0 119 000 usd the trader began with 100 000 usd and ended with 119 000 usd thus the profit is 119 000 100 000 19 000 thus the trader received a triangular arbitrage of 19 000 arbitrage is buying one asset and selling it in another market for a profit the technique can be used in many markets converting pairscurrency pair conversion is a fundamental concept in the currency market the value of one currency is quoted in terms of another currency each currency pair represents the exchange rate between two currencies and is used in forex trading to speculate on the relative strength of one currency against another the first currency listed in a currency pair is known as the base currency it s the currency being bought or sold the second currency is the quote currency which indicates how much is needed to buy one unit of the base currency in forex trading buying a currency pair implies buying the base currency and selling the quote currency conversely selling the pair means selling the base currency and buying the quote currency a direct quote occurs when the foreign currency is the base currency while an indirect quote is when the domestic currency is the base currency the bid price is what buyers are willing to pay for the base currency and the ask or offer price is what sellers are willing to accept the difference between these prices is the spread understanding currency pair conversion is crucial for forex traders since it helps them make informed decisions about buying and selling currencies based on their assessments of market conditions and economic indicators suppose a trader wants to convert 10 000 usd to eur the example below illustrates the basic process of converting from usd to eur taking into account exchange rates and bid ask spreads these factors are important for understanding how much foreign currency will be received and for making cost effective decisions when converting currencies the trader s first step is to check the exchange rate for eur usd the rates are assumed to be as follows the trader will sell the usd at the bid price and the trader will pay for eur at the ask price since the trader is buying eur the ask price will be used for the calculation to determine how many euros the trader will receive for 10 000 usd you ll need to do the conversion as follows amount in usd x exchange rate ask price 10 000 x 0 93023 9 302 30 eur