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Posted: Jun 14, 2006
If you're interested in getting into the forex market, there is one
relationship of which you must be aware before you even start trading. This is
the relationship between the euro and the Swiss franc currency pairs - a
correlation too strong to be ignored. In the article Using Currency
Correlations To Your Advantage, we see that the correlation between these two
currency pairs can be upwards of negative 95%. This is known as an inverse
relationship, which means that - generally speaking - when the EUR/USD (euro/
U.S. dollar) rallies, the USD/CHF (U.S. dollar/Swiss franc) sells off the
majority of the time and vice versa. When you're dealing with two separate and
distinct financial instruments, a 95% correlation is as close to perfection as
you can hope for. In this article we explain what causes this relationship,
what it means for trading, how the correlation differs on an intraday basis and
when such a strong relationship can decouple. Read on and you'll also find out
why, contrary to popular belief, arbitraging the two currencies to earn the
interest rate differential does not work.
Where Does This Relationship Come from?
In the article Using Currency Correlations To Your Advantage, we see that over
the long term (one year) most currencies that trade against the U.S. dollar
have an above 50% correlation. This is the case because the U.S. dollar is a
dominant currency that is involved in 90% of all currency transactions.
Furthermore, the U.S. economy is the largest in the world, which means that its
health has an impact on the health of many other nations. Although the strong
relationship between the EUR/USD and USD/CHF is partially due to the common
dollar factor in the two currency pairs, the fact that the relationship is far
stronger than that of other currency pairs stems from the close ties between
the eurozone and Switzerland.
As a country surrounded by other members of the eurozone, Switzerland has very
close political and economic ties with its larger neighbors. The close economic
relationship began with the free trade agreement established back in 1972 and
was then followed by more than 100 bilateral agreements. These agreements have
allowed the free flow of Swiss citizens into the workforce of the European
Union (EU) and the gradual opening of the Swiss labor market to citizens of the
EU. In fact, 20% of the Swiss workforce now comes from EU member states. But
the ties do not end there. Sixty percent of Swiss exports are destined for the
EU, while 80% of imports come from the EU. The two economies are very
intimately linked, especially since exports account for over 40% of Swiss GDP.
Therefore, if the eurozone contracts, Switzerland will feel the ripple effects.
What Does This Mean for Trading?
Figure 1
When it comes to trading, the near mirror images of these two currency pairs,
as seen in Figure 1, tell us that if we are long the EUR/USD and long USD/CHF,
we essentially have two closely offsetting positions or, basically, EUR/CHF.
Meanwhile, if we are long one and short the other, we are actually doubling up
on the same position, even though it may seem like two separate trades. This is
very important to understand for proper risk management because if something
goes wrong when we are short one currency pair and long the other, losses can
easily be compounded.
Intraday Relationship
However, this may be less of a problem for you if you are trading on an
intraday basis, because the correlation is weaker on shorter time frames. Just
take a look at the chart in Figure 2, showing one-week's worth of hourly bars.
The correlation, though still strong, oscillates from negative 64% to negative
85%. The reason for this variance is the possible delayed effect of one
currency pair on the other. More often than not, the EUR/USD marginally leads
the price in USD/CHF because it tends to be the more liquid currency pair.
Also, liquidity in USD/CHF can dry up sometimes in the second half of the U.S.
session when European traders exit the market, which means that some moves can
be exacerbated.
Figure 2
Why Arbitrage Does Not Work
Nevertheless, with such strong correlation, you will often hear novice traders
say that they can hedge one currency pair with the other and capture the pure
interest spread. What they are talking about is the interest rate differential
between the two currency pairs. At the time of writing (May 2006), the EUR/USD
had an interest rate spread of negative 2.50%, with the eurozone yielding 2.50%
and the U.S. yielding 5%. This meant that if you were long the EUR, you would
earn 2.50% interest per year, while paying 5% interest on the U.S. dollar
short. By contrast, the interest rate spread between the U.S. dollar and the
Swiss franc, which yields 1.25%, is positive 3.75%. As a result, many new
traders will ask why they cannot just go long the EUR/USD and pay 2.50%
interest and long USD/CHF to earn 3.75% interest - netting a neat 1.25%
interest with zero risk. This may seem like a lot of work to you for a mere
1.25%, but bear in mind that extreme leverage in the FX market can in some
cases be upwards of 100 times capital - therefore, even a conservative 10 times
capital turns the 1.25% to 12.5% per year.
The general assumption is that leverage is risky, but in this case, novices
will argue that it is not because you are perfectly hedged! Unfortunately,
there is no free lunch in any market, so although it may seem like this may
work out, it doesn't. The key lies in the differing pip values between the two
currency pairs and the fact that just because the EUR/USD moves one point, that
does not mean that USD/CHF will move one point too.
Differing Pip Values
The EUR/USD and USD/CHF have different point or pip values, which means that
each tick in each currency is worth different dollar amounts. The EUR/USD has a
point value of US$10 [((.0001/1.2795) x 100,000) x 1.2795], while USD/CHF has a
pip value of $8.20 [(.0001/1.2195) x 100,000]. Therefore, when these two pairs
move in opposite directions, they are not necessarily doing so to the same
degree. The best way to get rid of the misconceptions that some traders may
have about possible arbitrage opportunities is to look at examples of monthly
returns for the 12 months of 2005.
Let's say that we went long both the EUR/USD and USD/CHF in 2005. The table in
Figure 3 shows the price at the beginning of the month and at the end of the
month. The difference represents the number of points earned or lost. The
dollar value is the number of points multiplied by the value of each point ($10
in the case of the EUR/USD and $8.20 in the case of USD/CHF). "Interest income"
is the amount of interest earned or paid per month according to the FXCM
trading station at the time of publication, and the "sum" is the dollar value
earned plus the interest income.
Figure 3 - Profit/Loss for Long EUR/USD and Long USD/CHF positions
As you can see, the net return at the end of the year on two regular sized
100,000 lots is negative $2,439.
Some may argue that you need to neutralize the U.S. dollar exposure in order to
properly hedge. So we run the same scenario and hedge the USD/CHF by the dollar
equivalent amount for a euro each month. We do this by multiplying the USD/CHF
return by the EUR/USD rate at the beginning of each month, which means that if
one euro is equal to US$1.14 at the beginning of the month, we hedge by buying
US$1.14 against the Swiss franc.
Figure 4
As shown in Figure 4, the negative profit turns into a positive return, which
may seem great at first glance and may prompt many traders to buy into this
idea, but if we look at the flip scenario - where we went short both the EUR/
USD and USD/CHF - we see that what should have been a very similar return was
actually very different. The table in Figure 5 shows the total yearly return
based on 1 EUR/USD lot against 1 USD/CHF lot. The table in Figure 6 shows the
results of when we neutralized the dollar exposure and saw the profit turn into
a loss.
Figure 5
Figure 6
The fact that the numbers diverge so significantly, when theoretically they
should not have been that different because we are looking to earn just the
pure interest rate differential, tells us that - no matter how you cut it - the
two currencies cannot be hedged perfectly, even if you neutralize the dollar
exposure, because you simply end up with EUR/CHF. If the EUR/USD and USD/CHF
were perfectly hedgeable, then a chart of EUR/CHF would simply consist of a
straight line. However, taking a look at the chart in Figure 7, we see that
this is not the case. The example above that did turn into a profit did so
simply because we were directionally right in EUR/CHF. Most of the time, the
EUR/CHF does fluctuate in a tight range, but there are instances in which one
diverges from the other and this is when the correlations begin to deteriorate.
Figure 7
When Does the Relationship Decouple?
The relationship between the EUR/USD and USD/CHF decouples when there are
divergent political or monetary policies. For example, if elections bring on
uncertainty in Europe while Switzerland chugs merrily along, the EUR/USD might
slide further in value than the USD/CHF rallies. Conversely, if the eurozone
raises interest rates aggressively and Switzerland does not, the EUR/USD might
appreciate more in value than the USD/CHF slides. Basically, the fact that
ranges of the two currencies can vary more or less than the point difference,
as shown in Figure 8, is the primary reason why interest rate arbitrage in the
FX market using these two currency pairs does not work. The ratio of the range
is calculated by dividing the USD/CHF range by the EUR/USD range.
Date
EUR/USD
USD/CHF
Ratio of Range
1/31/2005
511
486
95%
2/28/2005
190
257
135%
3/31/2005
264
336
127%
4/29/2005
90
15
17%
5/31/2005
557
519
93%
6/30/2005
195
330
169%
7/29/2005
16
79
494%
8/31/2005
224
367
164%
9/30/2005
320
410
128%
10/31/2005
33
43
130%
11/30/2005
204
267
131%
12/30/2005
61
18
30%
1/31/2006
311
359
115%
2/28/2006
236
335
142%
3/31/2006
197
77
39%
4/28/2006
522
652
125%
Figure 8
To learn more about currency trading, see our Forex Walkthrough.
by Kathy Lien