Describe triangular arbitrage? What is a condition which will give increase to a triangular arbitrage opportunity?
Triangular arbitrage is the procedure of trading out of the U.S. dollar in a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The reason is to earn an arbitrage profit by means of trading from the second to the third currency while the direct exchange among the two is not in alignment along with the cross exchange rate.
Mostly, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market among non-dollar currencies, pricing at narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose discipline onto the non-dollar market makers. If their direct quotes are not consistent along with the cross exchange rates, a triangular arbitrage profit is possible.