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. In addition, this article explains why arbitraging the two currencies, in an attempt to capture 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 involved in 90% of all currency transactions. Furthermore, the U.S. economy is the largest in the world, which means that its strength impacts 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, due to 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. This was followed by more than 100 bilateral agreements that 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. And because two economies are intimately linked, if the eurozone contracts, Switzerland will feel the ripple effects.
What Does This Mean for Trading?
When it comes to trading, the near mirror images of these two currency pairs, 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.
Trading on an intraday basis is less risky because the correlation is weaker over a shorter period. 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.
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.
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.