Triangular arbitrage

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.

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.

[9] In observations of triangular arbitrage, the constituent exchange rates have exhibited strong correlation.

Transactions involving the JPY and CHF have demonstrated a smaller number of opportunities and long average duration around 01:00 and 10:00 UTC, contrasted with a greater number of opportunities and short average duration around 13:00 and 16:00 UTC.

This correspondence is substantiated by the observation of narrower bid-ask spreads during periods of high liquidity, resulting in a greater potential for mispricings and therefore arbitrage opportunities.

[9] Researchers have shown a decrease in the incidence of triangular arbitrage opportunities from 2003 to 2005 for the Japanese yen and Swiss franc and have attributed the decrease to broader adoption of electronic trading platforms and trading algorithms during the same period.

Such electronic systems have enabled traders to trade and react rapidly to price changes.

The speed gained from these technologies improved trading efficiency and the correction of mispricings, allowing for less incidence of triangular arbitrage opportunities.

[9] Mere existence of triangular arbitrage opportunities does not necessarily imply that a trading strategy seeking to exploit currency mispricings is consistently profitable.

In such a case, the arbitrageur will face a cost to close out the position that is equal to the change in price that eliminated the arbitrage condition.

"[9] The costs involved in keeping ahead in such a competition present difficulty in consistently beating other arbitrageurs over the long term.