Which is the better hedge of the following two options and why?
A) 1 lot short of EURJPY, 1 lot of long GBPJPY and 1 lot long of EURGBP
B) The volatility of GBPJPY = $1200 per day
The volatility of EURJPY = $700 per day
The volatility of EURGBP = $450 per day
0.15 lots long GBPJPY, 0.50 short EURJPY and 0.35 long EURGBP.
Basically, will you hedge based on volatility or just use the fact that GBPJPY*EURGBP=EURJPY?
I think you should have the same amount calculated in basecurrencies.
I think I have got a solution. Let me explain. Please post your comments here.
Let us consider GBPCHF, GBPUSD and USDCHF.
The Pip values and the Volatility in US$ for the pairs are as follows:
GBPCHF 8.18 868
GBPUSD 10.0 1270
USDCHF 8.18 794
Now, if we go long 0.59 lots of GBPCHF and short 0.25 lot of GBPUSD and 0.16 lot of USDCHF, the net volatility is almost zero.
0.25*10.0*1270 + 0.16*8.18*794 ~= 0.59*8.18*868. Thus, at the end of 20 days (that is the volatility I used), the net difference should be zero or very close to that. Using the swap rates posted on IBFX's website, the interest collected for each day will be $8.05. Thus, this appears to be a good hedge.
Hypothetically, if we use a $10k account and just use the above lots, we can earn 8.05*365 = $2,938 in interest with little risk. That is a 29% return per year. Of course, this assumes a lot of things remaining constant, but I hope I am able to explain the general idea.
Please post your comments and let me know if I have a bust in my calcs or assumptions. Thanks.
That will be short for both GBPUSD AND USDCHF?
Will a broker with continous interest calculation make any dofference?
I don't know if this will directly answer your question, but I think you'll find it interesting:
I hope it helps!
Thank you guys for your replies. I got the idea from the FPI concept. However, instead of trying the impeccable hedge, I am just trying a hedge based on pip values and volatility. Thus, the lot sizes need to be adjusted.
For aelimian... no, a broker with continuous interest should not make a lot of difference. There maybe some small differences, but nothing worthwhile in my view.
I don't know why volatility should matter. If I understand you right, I would say that you should have an equal amount(in the currency you prefer) for all three pairs.
So suppose your currency is the euro, then you could put 3 times 100000 euro in GBPUSD, in GBPCHF and in USDCHF. But that would mean something like 1.32 lots long in GBPUSD, 1.61 lots short in GBPCHF and 1.61 lots long in USDCHF.
Ahhh, I shoulda known you would have seen that already....
I am looking at volatility because I am trying to remain market neutral. Actually, I don't need the pip value if I am using Dollar volatility. I will change my spreadsheet and see what I come up with.
Volatility shows how big the average swing in a pair will be. But if I understand you correctly that shouldn't matter for your system. Because what you lose with one pair, you should gain with the other two. As long as the amount for all three are equal.
Your idea is nice. But how can you have an advantage in interest? A positive difference at one currencypair should be compensated by a loss at another pair. I looked at IBFX, but couldn't find the interest-rates. Or are you gonna use different brokers?
Check this link out for the swap rates.
Let us take a Long GBPJPY = Short GBPUSD*USDJPY
Long GBPJPY = 20.55
Short GBPUSD = 0.55
Short USDJPY = -15.10
Using 1 lot each, interest = 6.00
Thus, total per year = 365*6 = 2190.