If you're interested in getting into the forex market, there is one relationship that you must be aware of before you even start trading: 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?
Over the long term, 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. The two economies are very intimately linked. 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 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
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. For example, 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. For example, 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 the previous year.

Let's say that we went long both the EUR/USD and USD/CHF. 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. However, 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 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, 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.

The Bottom Line
Forex trading can be very profitable, if you know what you're doing and don't get fooled by misconceptions, and understanding the relationships between currencies is essential. The EUR/CHF relationship is a strong one, and if you play it right, it can pay off in the long run.

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