Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the primary condition for triangular currency arbitrage to be profitable?

1. The exchange rates must be equal

2. There must be discrepancies in the exchange rates

3. There should be minimal market volatility

4. High liquidity must exist in all currencies involved

The correct answer is: There must be discrepancies in the exchange rates

For triangular currency arbitrage to be profitable, there must be discrepancies in the exchange rates. This occurs when the cross exchange rates between three currencies do not align properly based on their respective direct exchange rates. If discrepancies exist, an arbitrager can exploit these differences by converting one currency into another through an intermediary currency to realize a profit. When the exchange rates are not in equilibrium, it creates an opportunity for arbitrage; the trader can buy a currency at a lower rate and sell it at a higher rate in a different market, thus making a profit from the discrepancies. This requires quick execution, as these opportunities can vanish rapidly as markets adjust to eliminate the inefficiencies. The other conditions mentioned, such as equal exchange rates, minimal market volatility, and high liquidity, while relevant to the broader context of currency trading, do not directly pertain to the necessity for profitable triangular arbitrage, which fundamentally relies on the existence of mispriced currency exchange rates.