BOSTON (TheStreet) -- Exchange rates can go years without grabbing headlines, but now it seems like every day the dollar hits a new high against the euro as concerns about Greece, Portugal and Spain make the euro look like a risky bet.
That volatility can make investing in currencies look tantalizing. But for novice investors who lack the training to forecast exchange rates, there's little to be gained and a lot to lose.
Currency traders are skilled in advanced trading strategies, which makes it difficult for average investors to get their foot in the door of the foreign exchange market. As soon as mispricings appear, they disappear as traders arbitrage away the discrepancy. One of the main strategies traders use to exploit these opportunities is known as triangular arbitrage.
Currency markets are some of the most interconnected in all of finance. Every exchange pair needs to jibe with every other pairing to eliminate the potential for risk-free profit. However, when markets are moving as much as they have been in recent weeks, sometimes exchange rates don't balance across all the pairings. These situations might only happen for less than a minute.
To exploit this opportunity, triangular arbitrage sends trades around in a circle to earn a risk-free profit based on the mispricing.
Consider the current exchange rates for dollars, euros and pounds. Yesterday, a euro cost $1.2271. This exchange rate can be checked against the rates for the dollar and British pound or the euro and the pound. Thanks to cross multiplication, the product of those two pairings should equal the dollar-euro exchange rate.
At their current levels, this relationship holds:
U.S. dollar vs. pound = $1.4376
Euro vs. pound = 0.8536 pound
$1.4376 x 0.8536 pound = $1.2271
The rates line up, so there's no arbitrage opportunity here.
Triangular arbitrage would kick in if the relationship resulted in any value other than 1.22. For example, if the dollar-pound exchange rate were $1.4276 instead of $1.4376 and the pound-euro rate remained at its current level, the projected dollar-euro exchange rate would be $1.2186.
To exploit the difference from the actual exchange rate, the investor would exchange dollars for pounds, pounds for euros and euros for dollars, resulting in a risk-free profit of 0.69 cent per dollar traded. While that amount may be small, currency traders shift millions of dollars to exploit the mispricing, giving them a profit of $6,975 per million dollars traded in a matter of seconds.
To find these opportunities, a trader would need to compare every currency pairing against every other currency every time the rates changed. It would require constant monitoring and immediate reactions to exploit the gap before it closes. This is literally impossible for an individual to do, so computers running algorithms look for these opportunities. As soon as a mispricing is spotted, big sums of money are traded at a moment's notice before the discrepancy disappears.
Ordinary investors are no match for professional investors that have access to the fastest computers and most advanced trading systems. Some might make a decent profit playing momentum trends and news events, but more exotic transactions are likely to lead to losses.
The best way for individual investors to profit from exchange rates is to consider the impact they have on stocks and economic growth. Trading at lightning speeds simply isn't feasible for someone running their own money on a
at home, but the economic implications of exchange rates can help investors make better investing decisions in less frenetic markets.
-- Reported by David MacDougall in Boston.
Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.