For traders on the forex market, the correlation between the euro and the Swiss franc currency pairs is too strong to be ignored. In the article "Using Currency Correlations To Your Advantage," the correlation between the two currency pairs is described as upwards of negative 95%. This represents an inverse relationship, which indicates that when the EUR/USD (euro/U.S. dollar) rallies, the USD/CHF (U.S. dollar/Swiss franc) mostly sells off and vice versa.

For two separate and distinct financial instruments, a 95% correlation is close to perfect. This article explains 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. Also, this article explains why arbitraging the two currencies to earn the interest rate differential does not work.

The Basis for the Relationship 

Over the long term, most currencies that trade against the U.S. dollar have a correlation above 50%. This is 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 strength has an impact on the strength 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 relationship is far stronger than that of other currency pairs because of the close ties between the eurozone and Switzerland.

Surrounded by other members of the eurozone, Switzerland has close political and economic ties with its larger neighbors. These ties and relationships began with the free trade agreement established back in 1972 and 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 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, shows that a position of long on EUR/USD and long on USD/CHF represents two closely offsetting positions or EUR/CHF. Meanwhile, taking a long position on one and a short position on the other is actually doubling up on the same position although it may seem like two separate trades. This is significant for proper risk management because if something goes wrong with a short position on one currency pair and a long position on another, losses can easily compound.

Intraday Relationship

Trading on an intraday basis is less risky because the correlation is weaker over a shorter period. Figure 2 shows one-week's worth of hourly bars. The correlation, although 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. Usually, the EUR/USD marginally leads the price in USD/CHF because it tends to be the more liquid currency pair. Additionally, liquidity in USD/CHF can abate in the second half of the U.S. session when European traders exit the market, which means that some moves can be exacerbating.

Figure 2

Why Arbitrage Does Not Work

Nevertheless, with such strong correlation, novice traders may attempt to hedge one currency pair with the other and capture the pure interest spread. Such traders are focusing on the interest rate differential between the two currency pairs. For example, the EUR/USD has an interest rate spread of negative 2.5% with the eurozone yielding 2.5%, and the United States yields 5% long on the EUR earning 2.5% 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, new traders may go long on EUR/USD and pay 2.5% interest and long on USD/CHF to earn 3.75% interest netting a neat 1.25% interest with zero risk. This may seem convoluted for a mere 1.25%, but that extreme leverage in the FX market can, in some cases, be upwards of 100 times capital. Therefore, even a conservative 10 times capital converts 1.25% to 12.5% per year.

The general assumption is that leverage is risky, but novices will argue to the contrary because a trader is perfectly hedged. Unfortunately, this is not the case. Differing pip values between the two currency pairs and a one-point movement in the EUR/USD does not mean that USD/CHF will also move one point.

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. Arbitrage opportunity can be better explained by examining the monthly returns for the 12 months of the previous year.

As an example, a trader goes long on 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

The table shows that the net return at the end of the year on two regular sized 100,000 lots is negative $2,439.

Some may propose neutralizing the U.S. dollar exposure to properly hedge. 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

Figure 4 shows that the negative profit turns into a positive return, which may prompt many traders to assume this strategy. However, if we look at the scenario of going short on both the EUR/USD and USD/CHF, what should be similar return is 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 with a neutralized dollar exposure and where the profit turns into a loss.

Figure 5
Figure 6

The fact that the numbers diverge so significantly when, theoretically, just the pure interest rate differential should be earned implies that the two currencies cannot be hedged perfectly. Even if you neutralize the dollar exposure, EUR/CHF is the result. If EUR/USD and USD/CHF could be perfectly hedged, the EUR/CHF chart would simply be a straight line.

However, Figure 7 shows this not to be the case. The example above that transitioned to a profit because the position was directionally correct for EUR/CHF. EUR/CHF does typically fluctuate in a tight range, but there are instances where one diverges from the other, and 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 uncertainty in Europe but not in Switzerland, 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. Because the ranges of the two currencies can vary more or less than the point difference, 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 profitable if traders do not fall prey to misconceptions, and they understand the relationships between currencies. The EUR/CHF relationship is a strong one and, if played correctly, can pay off in the long run.

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