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One of most important relationships to understand in the forex market is the one between the Swiss franc and euro. There is a very strong correlation between these two, meaning that the Swiss franc tends to rise against the US dollar when the euro does. Because of this, the EUR/ USD and USD/CHF currency pairs are strongly negatively correlated – the correlation can be as strong as -95%. In other words, when one currency pair rises, the other currency pair almost inevitably falls. Keep in mind that the two currency pairs run in opposite directions – if a CHF/ USD currency pair were used instead, both EUR/USD and CHF/USD would move together in the same direction nearly all of the time.

There are two main reasons for this correlation. First of all, the US dollar is the world’s top currency, and the US economy is also the largest. This means that the US dollar is involved in 90% of all currency trades, and the state of the US economy has a major impact on other economies around the world. This means that money tends to flow into and out of the US dollar, impacting all other currencies to some extent. Because of this, there is generally at least 50% or more correlation between currency pairs that involve the US dollar – the strength of the US dollar alone tends to overwhelm any particular strengths and weaknesses in other currencies when setting exchange rates.

However, the relationship between the Swiss franc and euro is even stronger than this. This is because Switzerland is situated directly in the middle of the eurozone, even though it is not part of it. Both the close physical proximity and strong trade ties tend to create a much stronger correlation between the two currencies than is found with other currencies. For example, strong growth in the eurozone translates into strong growth in Switzerland – creating similar upward pressure on both currencies.

Understanding this relationship is very important when managing risk. For instance, if you take a short position in USD/CHF and a long one in the EUR/USD, you are essentially doubling your risk. If the two currency pairs weren’t strongly correlated, then they could rise and fall independently. However, the correlation means that you will gain or lose on both positions at the same time – compounding your losses or profits.

In general, it is not a good idea because of this to trade both pairs. Some inexperienced traders also think that they can use differences in interest rates to carry out arbitrage with these two pairs – for example, going long on both currency pairs so that the risk is zero, and then pocketing the interest differences between the two pairs. However, for various reasons this often doesn’t work, particularly because the correlation is not perfect – the two currencies can decouple at times due to local economic and political factors.

 

Disclaimer:This written/visual material is comprised of personal opinions and ideas. The content should not be construed as containing any type of investment advice and/or a solicitation for any transactions. It does not imply an obligation to purchase investment services, nor does it guarantee or predict future performance. FXTM, its affiliates, agents, directors, officers or employees do not guarantee the accuracy, validity, timeliness or completeness of any information or data made available and assume no liability for any loss arising from any investment based on the same.

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