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Chapter 37, Part II. Application of Intramarket Correlations. Page 4

Discussion in 'Complete Trading Education- Forex Military School' started by Sive Morten, Dec 28, 2013.

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  1. Sive Morten

    Sive Morten Special Consultant to the FPA

    Aug 28, 2009
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    This is just an idea and example that use just two different pairs. In reality you can use as many pairs as you can, if they significantly improve your risk/reward ratio and allow you to hedge the risk. Our predefined parameters are as follows:

    1. The first pair will be AUD/JPY. Annual volatility from May 2002 is approximately 0.2, carry value 4.25%;

    2. Second pair let’s will be EUR/CHF. Annual volatility for same period is 0.08, carry value 1.00%:

    3. Correlation is 0.384.

    Now, we have to combine them so, to get maximum Carry/volatility ratio. For example, if you will use just AUD/JPY pair we will get 0.0425/0.2~0.213.

    Our total return on currency portfolio will be: AUD/JPY lot* Carry + EUR/CHF lot* Carry.

    Our total risk will be: AUD/JPY lot^2*Volatility^2 + EUR/CHF lot ^2*Volatility^2+2*Lot AUD/JPY*Lot EUR/CHF*Correlation*Volatility1*Volatilty2.

    So, if we will apply 50/50 we will get 2.62 annual carry and 0.122 Volatility of portfolio, so risk/volatility ratio will be 0.216.

    To calculate optimal weights of both currencies – you have to apply solution search tool in Excel. It will try all possible weights and choose optimal – that will lead to highest return/volatility ratio. This is 0.616 lot of AUD/JPY and 0.384 lot of EUR/CHF. In this case our carry will be 3% annually and volatility just 0.138. Hence risk/volatility ratio is 0.217 – the highest among all possible combinations:

    Return = 0.616*0.0425+0.384*0.01 = 0.03 or 3% annually

    Risk = (0.616^2*0.2^2+0.384^2*0.08^2+2*0.616*0.384*0.2*0.08*0.397)^0.5 = 0.138.

    Hence Return/Risk = 0.03/0.138 = 0.217.

    Pipruit: Cool! But sir, this is not eliminate the task of directional analysis – we have to know where particular pair is going to move, right?
    Commander in Pips: Of course. This application is not for replacing of trading and technical analysis. Mostly it could be used for portfolio investors to reduce currency risk if they apply carry trade in their investing framework. This is obvious that this is just an additional tool. It should be applied in line with overall fundamental analysis that we’ve discussed in the carry chapter.

    Also it’s worthy to be said here that we used just 2 currencies and correlation is rather solid. If you will find lower correlated pairs and acceptable balance of carries, maybe by using some exotic pairs, – this could give you greater opportunities.

    Pipruit: I see.

    P.S. This lesson was written by Sive Morten, who has been working for a large European Bank since April of 2000, and is currently a supervisor of the bank's risk assessment department. Sive's knowledge of forex market and banking industry is vast and quite complete. If you have any specific questions about forex, banking industry, or any other financial instruments, please post them below, we'll notify Sive, and get them answered within 1 week.

    Note: FPA ranks are earned in the battles against scam, not in the classroom.
    #1 Sive Morten, Dec 28, 2013
    Lasted edited by : Oct 14, 2016
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