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hedging one currency pair with another

  • #1
  • First Post: Feb 19, 2008 1:27pm Feb 19, 2008 1:27pm
Okay, I need to understand one thing here.

How is the position in 1 currency pair hedged with a position in another currency pair, how is the calculation done and how effective is it.

How is the hedging done for wednesday rollover.
  • #2
  • Feb 20, 2008 6:45am Feb 20, 2008 6:45am
Hedging is a rather complicated matter.

My knowledge in hedging is limited to my background in derivatives (interest rate swaps and options). In that part of the market, most hedging strategies are applied to reduce overall volatility in a portfolio or to lock in interest rates for a given period of time, usually the life/duration of the swap.

Hedging one currency with another works best in pairs that are closely correlated. (problem with that is that correlation between pairs is not constant) Pairs that work well together are €/$ vs $/CHF or Cable vs S/CHF although you can not produce an exact hedge. You can tailor the precise equivalent of your position size, but not the movement - that only works if you are exposed in one pair and you apply the opposite position in the same pair - some retail brokers call that hedging which is not really the case.

Hedging for single product (long/short) exposure is imo not really necessary since you can gauge and control your risk very easy. From my experience, hedging makes sense in an environment with multiple product and time frame exposure to multiple risk factors like geopolitical, short term interest rate, commodity risk, etc.

regards
daytrading
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  • #3
  • Feb 20, 2008 9:49am Feb 20, 2008 9:49am
most of my experience with hedging is in the options markets. with complex instruments like options there are a world of possibilities in how to structure your "market opinion". for instance, if i think a certain company is headed down the toilet, but there is a slim possibility the company might be bought, i might short the stock and buy OTM calls to hedge against the risk of the company being bought. there are millions of different scenarios like this.

sticking strictly to the forex market you have much fewer options because you can only go long or short. an example of a strict forex hedge: lets say you believe the dollar will weaken against the euro over the next year, for whatever reason. but you are worried the US trade balance might improve over the year, which would be a risk to your position. to hedge this risk, you might buy some USDJPY, knowing that strong US trade is bad for japan who is a big exporter to the US, and the strength resulting from the trade balance will have more effect on the USDJPY than the EURUSD. there are a number of scenarios like this, most related to inflation (especially oil prices), trade, and of course interest rates.

most hedging that ive seen (and employed) is done cross-market. for instance, if you want to short dollars, you could buy oil to hedge against the dollar rising. there are an infinite number of possibilities when you factor in the stock markets, commodity markets, bonds, etc etc.

forexlion, in your post it sounds like you have a specific kind of currency hedge in mind... care to expand on that? im not aware of any rollover hedge strategies (although i know of a few arbitrage opportunities that exist).
Relax and be happy.
  • #4
  • Feb 20, 2008 10:24am Feb 20, 2008 10:24am
I am totally new to this form of hedging scenario, so i wanted to collect more information on this subject.

Second, I have heard that brokers hedge our positions, how do they do that.

I am a newbie in the hedging context.
  • #5
  • Feb 20, 2008 8:57pm Feb 20, 2008 8:57pm
will you consider this? in retail level
we live with USD, buy USD/JPY with JPY as base currency....
if yen weaken, the position cover the loss, while the actual price is lessen
if yen strengthen, the position will lost, while the actual price is rising

i think it works on 1:1 true leverage
  • #6
  • Feb 20, 2008 11:47pm Feb 20, 2008 11:47pm
Quoting forexlion
I am totally new to this form of hedging scenario, so i wanted to collect more information on this subject.

Second, I have heard that brokers hedge our positions, how do they do that.

I am a newbie in the hedging context.
Most retail brokers keep trades in-house. That is, when you buy 10 lots USD/JPY, they are the ones selling them to you. Most of the time, there are others on the same broker that decide they want to sell USD/JPY, and the trades offset so that the broker has little to no risk but makes the spread.

When brokers "hedge" your positions, that means that they have a strong balance in one direction, so they pass the trade on to their counterparty banks. So say that 80% of the traders on a broker decide to buy USD/JPY. At the end of the day, the broker realizes that they have sold a large net USD/JPY position to their traders. Because most retail brokers typically don't want to speculate in the market (they just want to make the spread), the broker calls up their bank and places an order to buy the equivalent amount of USD/JPY. This makes them "flat" in the market - that is, they do not lose or gain money if the USD/JPY rate changes.

The broker's ultimate goal is to make money by friction - that is, whenever a trader wants to buy or sell, the broker makes just a small amount without typically taking any significant risk. When a broker realizes they are actually in a significant position and thus at risk, they want to hedge that risk by passing it on to the big bank.
  • #7
  • Feb 21, 2008 8:25am Feb 21, 2008 8:25am
Quoting merlin
most of my experience with hedging is in the options markets. with complex instruments like options there are a world of possibilities in how to structure your "market opinion". for instance, if i think a certain company is headed down the toilet, but there is a slim possibility the company might be bought, i might short the stock and buy OTM calls to hedge against the risk of the company being bought. there are millions of different scenarios like this.

sticking strictly to the forex market you have much fewer options because you can only go long or short. an example of a strict forex hedge: lets say you believe the dollar will weaken against the euro over the next year, for whatever reason. but you are worried the US trade balance might improve over the year, which would be a risk to your position. to hedge this risk, you might buy some USDJPY, knowing that strong US trade is bad for japan who is a big exporter to the US, and the strength resulting from the trade balance will have more effect on the USDJPY than the EURUSD. there are a number of scenarios like this, most related to inflation (especially oil prices), trade, and of course interest rates.

most hedging that ive seen (and employed) is done cross-market. for instance, if you want to short dollars, you could buy oil to hedge against the dollar rising. there are an infinite number of possibilities when you factor in the stock markets, commodity markets, bonds, etc etc.

forexlion, in your post it sounds like you have a specific kind of currency hedge in mind... care to expand on that? im not aware of any rollover hedge strategies (although i know of a few arbitrage opportunities that exist).
More eloquently stated Merlin & with a lot more detail but, as you mentioned, "there are an infinite number of possibilities when you factor in the stock markets, commodity markets, bonds, etc etc."
http://www.forexfactory.com/showpost.php?p=1855089&postcount=19
  • #8
  • Feb 21, 2008 1:23pm Feb 21, 2008 1:23pm
Quoting drummer486
When brokers "hedge" your positions, that means that they have a strong balance in one direction, so they pass the trade on to their counterparty banks.
the word "hedge" is a misnomer and as we have seen can be a source of confusion. for instance, when a broker takes an opposing market position to remove the risk of trader positions, i call this "offsetting" the position. in my vocab, the difference between "offsetting" and "hedging" is that there is still a chance for gain/loss with the hedge. the normal intention of a hedge is to still make some money while reducing the risk.

it would really help our discussions about hedging if there were a universal definition of hedging. fat chance there:
Relax and be happy.
  • #9
  • Feb 21, 2008 1:26pm Feb 21, 2008 1:26pm
Quoting daytrading
Hedging one currency with another works best in pairs that are closely correlated. (problem with that is that correlation between pairs is not constant) Pairs that work well together are €/$ vs $/CHF or Cable vs S/CHF although you can not produce an exact hedge. You can tailor the precise equivalent of your position size, but not the movement - that only works if you are exposed in one pair and you apply the opposite position in the same pair - some retail brokers call that hedging which is not really the case.
wouldnt this be considered arbitrage?? LOL
Relax and be happy.
  • #10
  • Feb 21, 2008 1:53pm Feb 21, 2008 1:53pm
Hi Merlin,

possibly to a degree - although arbitrage - as far as I know it - is the exploitation of price inefficiencies, often very small. We had a guy at WestLB who used to trade the bund futures front vs back month close to expiry in size DTB vs LIFFE. Also in my interbank deposit days we called synthetic pricing a form of arbitrage. We would buy 3X6 FRA and sell 6X12 FRA in order to create a marginally better synthetic 1 year price than available in the outright market.

One can do that in FX with triple arbitrage: €/$ vs $/Y ~ €/Y (very rarely is it possible to create a slightly different third-pair price by buying and selling the 2 corresponding pairs)

What I was referring to in my previous post is a kind of hedge: at certain times when for example €/$ and $/CHF were trading in a narrow range (with close correlation), I would enter both pairs in the same direction with a relatively close stop on both so that I am not missing the breakout of the stronger pair. Assuming the euro gets stronger, and I am long €/$ and $/chf, the $/chf long position will getstopped out while €/$ long position appreciates - before that break though, I am relatively hedged (or positioned with low risk) for either event: a stronger euro OR a stronger dollar.

regards
daytrading
Enter Signature
  • #11
  • Feb 21, 2008 7:44pm Feb 21, 2008 7:44pm
Quoting forexlion
I am totally new to this form of hedging scenario...
OK, I think I'm up for this discussion...

As long as one particular poster to this thread agrees that after "Private Discussion" what is agreed to be optimum is posted in response.

Not naming names but if "Merlin" ain't in, there's only a few others I would work with on this.

Chances are that most of those I'm thinking of will be around here long enough to finish this discussion {wouldn't That be nice} AND give it some Sticky Value.

In the event that this idea has legs, I would ask that you Post a SPECIFIC , Recently opened Position Trade,{or better yet, one you are anticipating} (if you don't know what I mean then, don't post, just read) {I'm reasonably sure that there will be a mutiple of "SPECIFIC Position Trade". But, at this time, let's aim for The Trade that is Elected.}

Then let's see if, to start, the team of us can calculate some "Other Market hedges" to reduce the risk on said Trade. It might just open your Life to Other Options of Income or Income Preservation.

So... Merlin... Ya wanna go for it?
If so... Open a thread in the 1KT & I'll see you there.
{OR wherever}
  • #12
  • Feb 21, 2008 7:48pm Feb 21, 2008 7:48pm
Quoting merlin
the word "hedge" is a misnomer and as we have seen can be a source of confusion. for instance, when a broker takes an opposing market position to remove the risk of trader positions, i call this "offsetting" the position. in my vocab, the difference between "offsetting" and "hedging" is that there is still a chance for gain/loss with the hedge. the normal intention of a hedge is to still make some money while reducing the risk.

it would really help our discussions about hedging if there were a universal definition of hedging. fat chance there:

Hi Merlin,

Ever thought of setting up a "FOREX Glossary" page or something like that on the Factory? I'm guessing that there's a lot of confusion and even some animosity in some threads which could be easily avoided if everyone was using the same set of definitions. Maybe a fourth main tab that we could access from any page in a single click.
  • #13
  • Feb 22, 2008 3:49pm Feb 22, 2008 3:49pm
Quoting Bemac
So... Merlin... Ya wanna go for it?
i cant say i know exactly what we are going for, but sure, im with ya! LOL
Relax and be happy.
  • #14
  • Edited 4:06pm Feb 22, 2008 3:51pm | Edited 4:06pm
Quoting capitalist88
Ever thought of setting up a "FOREX Glossary" page or something like that on the Factory?
yeah i have, but i have no pull anymore. i spent all of my political capital on the TR LOLOL
Relax and be happy.
  • #15
  • Feb 22, 2008 4:05pm Feb 22, 2008 4:05pm
Quoting daytrading
possibly to a degree - although arbitrage - as far as I know it - is the exploitation of price inefficiencies, often very small. We had a guy at WestLB who used to trade the bund futures front vs back month close to expiry in size DTB vs LIFFE. Also in my interbank deposit days we called synthetic pricing a form of arbitrage. We would buy 3X6 FRA and sell 6X12 FRA in order to create a marginally better synthetic 1 year price than available in the outright market.
yes i agree. very interesting tidbit there about yoru colleague.

Quoting daytrading
One can do that in FX with triple arbitrage: €/$ vs $/Y ~ €/Y (very rarely is it possible to create a slightly different third-pair price by buying and selling the 2 corresponding pairs)
this is what i thought you were talking about in your previous post, "triangulation" or whatever they call it. sorry i should have read that closer.

Quoting daytrading
What I was referring to in my previous post is a kind of hedge: at certain times when for example €/$ and $/CHF were trading in a narrow range (with close correlation), I would enter both pairs in the same direction with a relatively close stop on both so that I am not missing the breakout of the stronger pair. Assuming the euro gets stronger, and I am long €/$ and $/chf, the $/chf long position will getstopped out while €/$ long position appreciates - before that break though, I am relatively hedged (or positioned with low risk) for either event: a stronger euro OR a stronger dollar.
aha i see what you are saying now. i dont completely understand the reasoning though... this position would essentially give you a EURCHF position. why is it better to use two pairs than to trade the EURCHF outright? i think what i am missing is understanding what your bias is before initiating the trade. hedges usually require a bias because you are "hedging away" some of the risk to your bias. whereas arbitrage has no bias, you are trying to make money strictly by exploiting market inefficiencies, without having an opinion.
Relax and be happy.
  • #16
  • Feb 25, 2008 2:25am Feb 25, 2008 2:25am
Okay I have a question here.

I know that EUR/USD and USD/CHF have mirror image charts.

So if I go long in EU and also go long in UCHF

Then should EU fall, my position in UCHF will gain, and vice versa.

Is this how cross pair hedging is done ??
  • #17
  • Feb 25, 2008 12:27pm Feb 25, 2008 12:27pm
read the post i made right before yours. your scenario is equivalent to trading the EURCHF. im waiting on daytrading to see if he can enlighten me though...
Relax and be happy.
  • #18
  • Feb 25, 2008 1:36pm Feb 25, 2008 1:36pm
Quoting merlin
yes i agree. very interesting tidbit there about yoru colleague.


this is what i thought you were talking about in your previous post, "triangulation" or whatever they call it. sorry i should have read that closer.


aha i see what you are saying now. i dont completely understand the reasoning though... this position would essentially give you a EURCHF position. why is it better to use two pairs than to trade the EURCHF outright? i think what i am missing is understanding what your bias is before initiating the trade. hedges usually require a bias because you are "hedging away" some of the risk to your bias. whereas arbitrage has no bias, you are trying to make money strictly by exploiting market inefficiencies, without having an opinion.
Hi Merlin,

During the above mentioned scenario the swiss franc is merely a vehicle - or neutral ground for the two other currencies to increase/decrease against.

If I had a eur/chf outright position, I would also (in my scenario) have to have a bias on chf (not only on euro). I only have a bias on usd and euro...but I don't know which one is going to make the move....so I need a position in both, but I cannot go long in both through a position in eur/$ alone....I need another position where I am long dollar agains a currency that has a close correlation to eur/$ to stay in 2 positions with similar risk.

In all this, I have to say though that using the term hedge could be completely misplaced. As I have mentioned earlier in the thread, I believe that proper portfolio based hedging has nothing to do with trying to contain the risk of one or two outright fx positions.....let alone the so called hedge some retail brokers offering where you take the exact opposite trade to an existing one in order to achieve what: have two trades open and none of them does anything? One might as well close the first one and get the same result.

Anyway, I am all ears to hear from someone who is more versatile than myself in the correct way of hedging.

regards
daytrading
Enter Signature
  • #19
  • Edited 3:14pm Feb 26, 2008 1:39pm | Edited 3:14pm
as most of you have probably noticed, currency pairs math works exactly like fractions. you can use all the same shortcuts as you can use with fractions as well, such as canceling out numerators and denominators.

for instance, if you are long the EURUSD and long the USDCHF, mathematically you can view your position like this...

EUR * USD
USD _CHF

and just like a fraction, the USDs cancel eachother out...

EUR * USD = EUR
USD__CHF__ CHF

so, mathematically, being long the EURUSD and USDCHF is equivalent to being long EURCHF (although you would have to carry different sizes of each pair to make them truly balance).

basically my argument is that anything you can do with EURUSD and USDCHF can be replicated trading EURCHF, and probably for a cheaper spread.
Relax and be happy.
  • #20
  • Feb 26, 2008 3:12pm Feb 26, 2008 3:12pm
And to further illustrate Merlin's point, the prices will remain in synch as well. If you multiply the prices like this:

EUR/USD x USD/CHF, you will get the price of EUR/CHF.

More complex example? No problem. Here's a screenshot of 5 pairs which illustrate the idea all in one equation.

Attached Image


AUD/NZD x NZD/USD x USD/CAD x CAD/JPY = AUD/JPY

1.1448 x 0.8147 x 0.9822 x 109.25 = 100.08

I used the offers for all of them. There will sometimes be some discrepancies of a few pips, but almost never enough to beat the spreads for more than half a second.


Quoting merlin
as most of you have probably noticed, currency pairs math works exactly like fractions. you can use all the same shortcuts as you can use with fractions as well, such as canceling out numerators and denominators.

for instance, if you are long the EURUSD and long the USDCHF, mathematically you can view your position like this...

EUR + USD
USD _CHF

and just like a fraction, the USDs cancel eachother out...

EUR + USD = EUR
USD__CHF__ CHF

so, mathematically, being long the EURUSD and USDCHF is equivalent to being long EURCHF (although you would have to carry different sizes of each pair to make them truly balance).

basically my argument is that anything you can do with EURUSD and USDCHF can be replicated trading EURCHF, and probably for a cheaper spread.
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