FREE online courses on Investment Decisions in Exchange Rates - Triangular Arbitrage

 

Given the exchange rate between the dollar and the British Pound, S$/£ , and the exchange rate between the dollar and the German Mark, S$/DM , the exchange rate between the German Mark and the British Pound,  SDM/£  , should be

 

                   SDM/£           =     .

 

For example, if the exchange rate between the dollar and the British Pound is $1.50/£1 and the exchange rate between the dollar and the German Mark is $.75/DM1, the exchange rate between the German Mark and the British Pound is

 

                   SDM/£           =     ,

 

                             =     DM2/£1 .

 

If the exchange rate between the German Mark and the British Pound were either greater or less than DM2/£1, then a triangular arbitrage opportunity will be available.  For example, suppose that the Mark/Pound exchange rate were DM2.1/£1.  Then a trader with two German Marks would    (1) exchange them for $1.50 (2 x $.75/DM1).  The $1.5 would then (2) be exchanged for one British Pound, which would then (3) be used to purchase DM 2.1, which is greater than the number of German Marks that the trader started with.