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    Triangular_Arbitrage_Problem

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    Christine Julius

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    Triangular_Arbitrage_Problem

    Uploaded by

    Christine Julius
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    11 views3 pages

    Triangular_Arbitrage_Problem

    Uploaded by

    Christine Julius

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    © All Rights Reserved
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    You are on page 1of 3

    FN 300: Triangular Arbitrage Problem with Bid and Ask Rate

    Question
    You are a currency trader dealing in TZS (Tanzanian Shillings), USD (United States
    Dollar), and KES (Kenyan Shillings). The following exchange rates are available to you:

    1. TZS/USD:
    - Bid: 2,300 TZS | Ask: 2,310 TZS
    2. USD/KES:
    - Bid: 145 KES | Ask: 147 KES
    3. TZS/KES:
    - Bid: 16.50 TZS | Ask: 16.70 TZS

    You have 10,000,000 TZS. Determine whether there is an opportunity for triangular
    arbitrage, and if so, calculate the profit.

    Solution
    Step 1: Understanding Cross Rates and Pairing Bid and Ask Rates
    When computing cross rates, we always pair the bid rate from one quotation with the ask
    rate from another quotation. This pairing ensures the cross rate reflects the most
    conservative or realistic values, as banks always buy low (Bid) and sell high (Ask).

    Key principles:
    1. For a cross rate Bid, we use the Bid from one pair and the Ask from the other pair.
    2. For a cross rate Ask, we use the Ask from one pair and the Bid from the other
    pair.
    The lowest resulting cross rate becomes the Bid, and the highest becomes the
    Ask, as banks always buy low and sell high.
    Step 2: Pairing the Rates for TZS/KES
    To compute TZS/KES, we use the relationship between TZS/USD and USD/KES:
    - TZS/USD: Bid = 2,300 TZS | Ask = 2,310 TZS
    - USD/KES: Bid = 145 KES | Ask = 147 KES
    Formula: TZS/KES = TZS/USD × USD/KES.

    For TZS/KES Bid, pair:


    - TZS/USD Bid (2,300 TZS per USD) with USD/KES Ask (147 KES per USD).
    For TZS/KES Ask, pair:
    - TZS/USD Ask (2,310 TZS per USD) with USD/KES Bid (145 KES per USD).

    Step 3: Compute the Implied Cross Rates


    1. Note: For simplicity after computing the cross rate, the lowest rate becomes
    the implied BID Rate and the highest one becomes the implied ASK Rate.
    Hence;

    CPA. Dr. Mkaro Goodhope


    2. Implied TZS/KES Bid = TZS/USD Bid ÷ USD/KES Ask = 2,300 ÷ 147 ≈ 15.65
    TZS per KES.
    3. Implied TZS/KES Ask = TZS/USD Ask ÷ USD/KES Bid = 2,310 ÷ 145 ≈ 15.93
    TZS per KES.

    Step 4: Compare Implied Cross Rates to Quoted TZS/KES Rates


    Quoted TZS/KES:
    - Bid = 16.50 TZS per KES
    - Ask = 16.70 TZS per KES.

    Implied TZS/KES:
    - Bid = 15.65 TZS per KES
    - Ask = 15.93 TZS per KES.
    Observation: (You can either choose to compare BID against BID or ASK against
    ASK)
    The quoted TZS/KES Bid (16.50) is higher than the implied Bid (15.63), indicating that
    KES is overvalued in the market compared to its implied value. As such TZS is
    undervalued by the market.

    Step 5: Define the Arbitrage Cycle


    Since the KES is overvalued, we can profit by executing the following cycle:
    1. Start with TZS (The undervalued currency).
    2. Convert TZS to USD-The common currency used to obtain the cross rate. (using the
    TZS/USD Ask Rate).
    3. Convert USD to KES (using the USD/KES Bid Rate).
    4. Convert KES back to TZS (using the TZS/KES Bid Rate).

    Step 6: Execute the Arbitrage Steps


    1. Convert TZS to USD:
    USD Received = 10,000,000 ÷ 2,310 ≈ 4,329.00 USD.
    2. Convert USD to KES:
    KES Received = 4,329.00 × 145 ≈ 627,705.00 KES.
    3. Convert KES to TZS:
    TZS Received = 627,705.00 × 16.50 ≈ 10,356,132.50 TZS.

    Step 7: Calculate the Profit


    Profit = Final TZS Received - Initial TZS = 10,356,132.50 - 10,000,000 = 356,132.50
    TZS.

    Final Answer
    Yes, there is an arbitrage opportunity. The profit is 356,132.50 TZS.

    CPA. Dr. Mkaro Goodhope


    Note on Cross Rates
    Whenever you have bid and ask rates and need to compute a cross rate:
    1. Pair Bid vs. Ask from different quotations to ensure the most conservative estimate.
    2. The lowest resulting cross rate becomes the Bid, and the highest becomes the Ask, as
    banks always buy low and sell high.
    For example:
    - For TZS/KES Bid, pair TZS/USD Bid (the least TZS you get per USD) with USD/KES
    Ask (the most USD you pay per KES).
    - For TZS/KES Ask, pair TZS/USD Ask with USD/KES Bid.

    CPA. Dr. Mkaro Goodhope

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