So I’m reviewing Econ, and I can’t come up with a way to remember how to take advantage of a triangular arbitrage opportunity. I’ve got down how to detect if it is available and which currency you ultimately want to buy or sell depending on the situation, but I know I am going to forget how to take advantage of the arbitrage opportunity. Take a look at the example on CFAI pg. 560. Does anybody have a good way of remembering the process of taking advantage of arbitrage opportunities?
My way: Skip it and move on to something else. I’ll risk losing 3 points on one question and move on to more important stuff: equity, FSA, ethics (50%+ of the exam)!
Say the forward price of CHF is overpriced in a CAD/CHF relationship. 1. Borrow CAD. 2. Buy CHF at the spot, since forward price is overvalued, you can buy at the spot and hold until delivery and physically deliver for an arb free gain. 3. Sell CHF Forwards - It is overvalued, so by selling the forwards and physically delivering what you hold at the spot will capture your gains. 4. With the proceeds from the forwards, pay back CAD or continue the cycle of buying more spots, selling more forwards until the market forces the prices to converge. Someone fill in the gaps, I’m missing something here, but the story above is what helped me along.
Draw a triangle with each currency as its vertices. Then for each directed edge, write down the currency translation rate. e.g. for the edge goes from USD to Yen. If the USD : YEN is 95.00-02, write down 95. The edge from Yen to USD is 1/95.02. (Remember the rule: UP the BID, DOWN the ASK. Given a currency rate B / A with bid-ask rate x-y. If you convert from A to B, use the bid rate x. If you convert from B to A, use the ask rate 1/y.) Repeat this process until all 6 edges (2 edges between each pair of vertex) are filled in. Then go clockwise and multiply the number on the edges in one direction. After, go counter-clockwise and repeat the process. If the numbers are not equal, you have a triangular arbitrage opportunity.
To Quant: I think you’re thinking of a different kind of arbitrage from the Forward Contracts reading of Derivatives. I’m talking about triangular arbitrage involving three currencies. It’s in reading 18 in Econ.
just remember the formula: (1+rd) - ((1+rf)(F))/S if its a positive number, borrow foreign at rf and lend domestic at rd if negative, do the opposite. this took awhile for me too, i finally hit a schweser qbank question that just made total sense…remember the formula and the rest will become easy points if it shows. nevermind, I see you are looking at a dif kind of arb…remember when converting around the triangle that you always get screwed, you get the worst deal on converting.
I just reviewed what you are talking about, this is hard to put in words. Use my story above, and start hammering qbank questions. I need to do the same.
I think you’re right Quant. Doing questions on this topic is probably the best way to learn it, because reading about how to take advantage of triangular arb makes my brain hurt.
Let me see if I understand. It’ll help me review and feel free to correct. using quotes from XE.com for currency CAD,USD,GBP as of now CAD/USD is 1.17755 USD/GBP is 1.51551 if a dealer quotes anything different from 1.78459 from (1.17755*1.51551) there would be arbitrage opportunity btw if bid/ask are included you multiply the bid with bid and ask with ask if you get inverse quotation, the bid inverted would become the ask so be careful BTW IRP does not hold by arbitrage…
That’s right Jo_l, provided you meant that the 1.78459 is the CAD/GBP rate.
yea forgot to mention that. thanks for correcting
… and if you see no risk-free profit in one direction, try the other direction.