Stat arb/ relative value trades of assets in different currencies

[TraDaToR]

Hello,

I have never traded spread between assets denominated in different currencies? Let's say you want to go long the equivalent of 200 K$ of Kansas City wheat against 183 K Euros of milling wheat( equivalent amounts )... How do you neutralize the currency exposure? Are you doing it in cash forex or currency futures in the related expiry?

Thanks a lot.

 

[tom_czr]

Cash forex...

1. Long Kansas wheat -> -$200K
2. Short Milling wheat -> we suddenly have +183K EUR (equivalent +$200K in time of enter) in cash on our account
3. FX trade selling 183 K EUR and buying 200K USD (EUR/USD) -> we have 0K EUR and 0K cash balance change


Lets assume, that EUR becomes:
1. Stronger and price of both wheat contracts does not change. Then we are making money on our short milling wheat in EUR and hedging it out (loosing money) on our FX trade.
2. Weaker and price of both wheat contracts does not change. Then we are loosing money on our short milling wheat in EUR and hedging it out (making money) on our FX trade.

 

[kurga]

Cash forex...

1. Long Kansas wheat -> -$200K
2. Short Milling wheat -> we suddenly have +183K EUR (equivalent +$200K in time of enter) in cash on our account
3. FX trade selling 183 K EUR and buying 200K USD (EUR/USD) -> we have 0K EUR and 0K cash balance change


Lets assume, that EUR becomes:
1. Stronger and price of both wheat contracts does not change. Then we are making money on our short milling wheat in EUR and hedging it out (loosing money) on our FX trade.
2. Weaker and price of both wheat contracts does not change. Then we are loosing money on our short milling wheat in EUR and hedging it out (making money) on our FX trade.

Hi Tom,
shouldn't it be sell usd buy eur in 3.? for the hedge. Best,
K

 

[TraDaToR]

No. I think Tom is right. At first I came up with his hedge and thought perhaps the same as you:"Wait, I am going long some $ denominated wheat AND long the USD???"but yes, independently from the spread, if the EUR goes down and wheat keep same value, then the wheat is worth more EUR, so you are losing on your EUR wheat position so you need to be short EUR...

 

[tom_czr]

to kurga:
If you are (want to be) succesful trader, you should never guess, you should do math all the time. Excel helps a lot...

Three screenshots from my Excel show the math behind my assumtions. If you want to have our own investors / be advisor / provide signals, you should be careful about your posts, because your potential clients will "google" you before providing their capital.

I mean it in good way Best regards, Tom

 

[TraDaToR]

A new question on this subject. Let's say if the 2 assets "cointegrate"( I don't know if it is the right word ) perfectly with a number of contracts representing different amounts of capital invested. For example here let's say Milling wheat is more volatile per dollar invested so it is better to spread 150K Euros EBM Vs 200K $ KW, how do you handle the currency hedging as the 2 entries are not equivalent ( 150 K EUR < 200 K $ )? Intuitively I would hedge the average between the 2 amounts of capital...Am I right?

 

[H2O]

A new question on this subject. Let's say if the 2 assets "cointegrate"( I don't know if it is the right word ) perfectly with a number of contracts representing different amounts of capital invested. For example here let's say Milling wheat is more volatile per dollar invested so it is better to spread 150K Euros EBM Vs 200K $ KW, how do you handle the currency hedging as the 2 entries are not equivalent ( 150 K EUR < 200 K $ )? Intuitively I would hedge the average between the 2 amounts of capital...Am I right?

Try to take a step back.. What are you trying to achieve?

As per your initial post you are trying to neutralize the impact of FX moves on the outcome of your trade. Therefore, you should only hedge the none-base currency you have exposure to.

In case you are a USD based investor, you should sell €150k, buy $
If you are a EUR based investor, you should buy $200k, sell €

If you are entering into a trade between 2 'foreign' currencies (From previous posts I understand you are Swiss based) you could either enter into 2 trades (USD/CHF and CHF/EUR) or use the cross between the trade currencies (USD/EUR) to offset most of your risk, and remove the residual exposure through a USD/CHF hedge (in this case) if desired.

Remember you also may have to adjust your hedge depending on the movement in the underlying contract. Example: Let's assume both contracts move sharply, but your spread remains unchanged. You are now exposed to a significantly larger amount of FX.

This brings us to another question which is at least as important: As per your post above, you undertook some cointegration testing. Are your time-series still cointegrated when adjusted for FX moves? (in other words, what is the impact of FX hedging on the expected outcome of your system?)

Hope this helps

 

[TraDaToR]

Try to take a step back.. What are you trying to achieve?

As per your initial post you are trying to neutralize the impact of FX moves on the outcome of your trade. Therefore, you should only hedge the none-base currency you have exposure to.

In case you are a USD based investor, you should sell €150k, buy $
If you are a EUR based investor, you should buy $200k, sell €

If you are entering into a trade between 2 'foreign' currencies (From previous posts I understand you are Swiss based) you could either enter into 2 trades (USD/CHF and CHF/EUR) or use the cross between the trade currencies (USD/EUR) to offset most of your risk, and remove the residual exposure through a USD/CHF hedge (in this case) if desired.

Remember you also may have to adjust your hedge depending on the movement in the underlying contract. Example: Let's assume both contracts move sharply, but your spread remains unchanged. You are now exposed to a significantly larger amount of FX.

This brings us to another question which is at least as important: As per your post above, you undertook some cointegration testing. Are your time-series still cointegrated when adjusted for FX moves? (in other words, what is the impact of FX hedging on the expected outcome of your system?)

Hope this helps

Thanks. It's a good way to think about it, neutralizing the foreign denominated asset...And it makes sense to only hedge the milling wheat part if my account is in USD...

There is just something arbitrary to me in the values of contracts but I can't put a name on it...Sometimes some positions representing 150 K EUR of x commodity moves more daily than other representing 200 KEUR and the full currency hedging of those low volatility contracts seems excessive...Whatever.

My cointegration test is done using currency hedging in the tests... For example I would cointegrate KW with EBM * EURUSD if that's what you are asking.

 

[H2O]

My cointegration test is done using currency hedging in the tests... For example I would cointegrate KW with EBM * EURUSD if that's what you are asking.

Just remember that in this case you are hedging the actual EUR exposure of the current contract value. In order to translate this into actual trading you would need to adjust your EUR hedge on every update. (Very impractical unless your data frequency is pretty low..)

 

[TraDaToR]

Capiche...