1. Triangular and Locational Arbitrage Bill Reese International Finance 1

2. Learning Objectives In this unit we will learn:  How to execute triangular arbitrage Why cross-rates generally prevent triangular arbitrage  How to execute locational arbitrage Why XR quotes generally prevent locational arbitrage 2

3. Triangular Arbitrage Single XR example: 0.8155 €/$ 1.3235 CD/$ 0.635 €/CD “Fair” crossrate 0.8155 €/$ = 0.61617 €/CD 1.3235 CD/$ 3

4. Triangular Arbitrage 0.61617 €/CD = fair rate 0.635 €/CD = actual rate CD is expensive € is cheap Sell the expensive currency: Canadian dollars Buy the cheap currency: Euros 4

5. Triangular Arbitrage € $ CD 5

6. Triangular Arbitrage € 840,422.5 $ 1million CD 1,323,500 6 $ 1,030,561

7. Triangular Arbitrage Start with $1 million Earn riskless profit of $30,561 Cannot remain for long in competitive markets  Price of CD drops from selling  Price of euro rises from buying  Actual cross-rate adjusts 7

8. Triangular Arbitrage Dual XR example: 8 Bid (indirect)Ask (indirect) 1.25 SF/$1.28 SF/$.812 €/$.818 €/$ 1.58 SF/€1.60 SF/€ Bid (direct)Ask (direct) 0.78125 $/SF0.80 $/SF 1.2225 $/€1.2315 $/€ 0.625 €/SF0.6329 €/SF

9. Triangular Arbitrage Fair crossrates Bid: 1.25 SF/$ = 1.539 SF/€.812 €/$ Ask: 1.28 SF/$ = 1.565 SF/€.818 €/$ Actual crossrates > fair crossrates 9

10. Triangular Arbitrage Euro should equal (cost) 1.539 or 1.565 SF Actually costs 1.58 or 1.60 SF Euro is expensive Swiss Franc is cheap Buy cheap currency (SF) Sell expensive currency (€) 10

11. Triangular Arbitrage SF $ € 11

12. Triangular Arbitrage Start with $1,000  Sell $ at.812 €/$ (indirect bid) Or buy euros at 1.2315 $/€ (dir ask) Now own €812  Sell euros at 1.58 SF/€ (indir bid) Or buy SF at 0.6329 €/SF (dir ask) Now own SF 1,282.96  Sell SF at 0.78125 $/SF (dir bid) Or buy $ at 1.28 SF/$ (indir ask) Now own 1,002.31 12

13. Triangular Arbitrage SF 1,282.96 $1,000 €812 13 $1,002.31

14. Triangular Arbitrage Will go away as investors  Sell dollars and buy euros Bid price drops from.812 €/$  Sell euros and buy SF Bid price drops from 1.58 SF/€  Sell SF and buy dollars Ask price goes up from 1.28 SF/$ 14

15. Triangular Arbitrage SF/$ goes up €/$ goes down “Fair” crossrate SF/€ goes up Actual crossrate SF/€ goes down “Fair” crossrate equals actual in equilibrium 15

16. Locational Aribrage Example Do you see the arbitrage opportunity? 16 Dealer ADealer B BidAskBidAsk 2680 Peso/$2683 Peso/$2685 Peso/$2688 Peso/$

17. Locational Aribrage Note: ask price of A < bid price of B 17 Dealer ADealer B BidAskBidAsk 2680 Peso/$2683 Peso/$2685 Peso/$2688 Peso/$

18. Locational Aribrage Buy dollars from A and sell them to B  Start with 1 million pesos  Purchase $372.72 from A  Sell them to B for 1,000,745 pesos 18 Dealer ADealer B BidAskBidAsk 2680 Peso/$2683 Peso/$2685 Peso/$2688 Peso/$

19. Locational Aribrage Investors buy dollars from A  Ask price of A goes up Investors sell dollars to B  Bid price of B goes down 19 Dealer ADealer B BidAskBidAsk 2680 Peso/$2683 Peso/$2685 Peso/$2688 Peso/$