Intraday Relationship

This may be less of a problem for you if you are trading on an intraday basis, because the correlation is weaker on shorter time frames. Just take a look at the chart in Figure 2, showing one-week's worth of hourly bars. The correlation, though 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. More often than not, the EUR/USD marginally leads the price in USD/CHF, because it tends to be the more liquid currency pair. Also, liquidity in USD/CHF can dry up sometimes in the second half of the U.S.session, when European traders exit the market, which means that some moves can be exacerbated. 

Figure 2

Why Arbitrage Does Not WorkNevertheless, with such strong correlation, you will often hear novice traders say that they canhedge one currency pair with the other and capture the pure interest spread. What they are talking about is the interest rate differential between the two currency pairs. For example, the EUR/USD had an interest rate spread of negative 2.50%, with the eurozone yielding 2.50% and the U.S. yielding 5%. This meant that if you were long the EUR, you would earn 2.50% 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%. 

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As a result, many new traders will ask why they cannot just go long the EUR/USD and pay 2.50% interest and long USD/CHF to earn 3.75% interest, netting a neat 1.25% interest with zero risk. This may seem like a lot of work to you for a mere 1.25%, but bear in mind that extreme leverage in the FX market can, in some cases, be upwards of 100 times capital. Therefore, even a conservative 10 times capital turns the 1.25% to 12.5% per year. 

The general assumption is that leverage is risky, but in this case, novices will argue that it is not, because you are perfectly hedged. Unfortunately, there is no free lunch in any market, so although it may seem like this may work out, it doesn't. The key lies in the differing pip values between the two currency pairs and the fact that just because the EUR/USD moves one point, that does not mean that USD/CHF will move one point too.

Differing Pip ValuesThe 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. The best way to get rid of the misconceptions that some traders may have about possible arbitrage opportunities, is to look at examples of monthly returns for the 12 months of the previous year. 

Let's say that we went long 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.