Long EUR/Short CHF: A Possible Trade With A High Risk-Reward Ratio

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Since September 2011 the Swiss franc has lost a large portion of its appeal as a safe haven currency. The pledge of the Swiss National bank to defend the 1.20 floor it pegged the franc against the euro was tested several times by the market and survived. As a result the recent foreign exchange reserves of the SNB increased to CHF 365 billion as of Q2 2012 (an advance of CHF 108 billion since 31.12.2011).

The minimum exchange rate of the franc against the euro changed significantly the investment characteristics of the EUR/CHF pair. Since the peg was introduced it lowered the pair's monthly volatility (measured by the standard deviation of returns) to 1.49% as of August 2012 (from a value of 3.65% for the year before the peg). Because the currency was no longer perceived as a reliable store of value due to the strong player that has expressed opposite intentions, many market participants turned away from trading the pair. This normally decreased its volatility.

The peg also changed significantly the correlations between EUR/CHF, USD/CHF and EUR/USD pairs. A normal move before the peg would be for the franc to appreciate whenever the euro decreased in value against the U.S. dollar. Hence a positive correlation was underway. Since the peg the correlation between the EURUSD and EURCHF pairs has become negative.

A summary of those changed characteristics follows:

EURUSD EURCHF USDCHF Standarad Deviations of Returns

EURUSD EURCHF USDCHF Correlations of Monthly Returns

The negative correlation between EURUSD and EURCHF pairs combined with the lower volatility (and currently practically zero downside volatility when the rate is close to or at the pig level) could make a long euro position in the EURCHF pair a nice addition to a portfolio as it will lower the variance of the whole portfolio according to the modern portfolio theory.

Given the practically close to zero downside movement since the peg was introduced and the rate converged to the peg level, such an investment combined with a suitable stop loss order would also exhibit characteristics of a call option. It could present a significant upside potential while the downside risk is limited by the peg or the stop order. If the loss level is to be set at 15-20 pips below the entry point and the trade is entered at or around the peg level (1.2000/10) any upside movement to more than 1.2030 would present a positive risk-reward ratio. Thus such an investment could not only lower the overall portfolio variance but also could present nice risk adjusted returns.

In order to examine the possibility to achieve any profit on the trade we could consider some of the fundamental characteristics below the EURCHF recent movement.

Having in mind the pledge to defend the floor, the closer the EURCHF value gets to the floor, the higher the probability of a SNB intervention by buying the available euros with francs. The higher the EURCHF rate goes the lower this probability gets. At the higher rate the SNB would not be so eagerly willing to buy euros as defending the peg would not be an imminent task. Diversifying the foreign exchange reserves so they would not carry too much risk would become paramount. As the bank has obliged itself to buy euro this is the currency it would try to diversify most of the time. This is done mostly by selling part of the euros held for other currencies. The SNB balance sheet shows that for the first quarter of 2012 the bank managed to replace a considerable amount of euros with other major currencies such as the U.S. Dollar and the British Pound. The portions of both currencies in the foreign reserves increased while the euro's part was down to 50.5% from a previous reading of 57%. Such a move could partly explain the recent USD and GBP appreciations against the euro besides the fundamental reasons like the peripheral countries liquidity problems.

For the Q2 of 2012 however the SNB did not sell euro in such a manner and the amount held rose with about 77% for the quarter. The foreign reserves increased with almost 49% to CHF 365 billion. The euro's portion of the bank's reserves increased to 60.1%. The USD increased with a more modest step of 18% but its portion of the holdings decreased to 21.7%. Recently the bank released its financial results for the first half of 2012 which showed a profit of CHF 6.5 billion. CHF 5.1 billion of those were gains from foreign currency positions realized during the second quarter.

The main idea of the peg was to support the Swiss economy whose exports were suffering due to the rapid appreciation of the country's currency to almost a parity with the euro. Given this logic increasing the availability of francs to depreciate the currency seems perfectly fitted to the both tasks - protecting the peg level by selling francs for euros and supporting the exporters and economy by increasing the money supply and devaluing the franc.

A problem that many market participants see and that has the potential to break the profitability of a long euro trade in the EURCHF pair is connected with the SNB having to aggressively defend the floor for a significant period of time, accumulating too much euros in the bank's reserves and not being able to diversify them properly and on time. A recent Bloomberg article presents some remarks on this. According to Maxime Botteron, an economist at Credit Suisse Group AG (CSGN) in Zurich, as long as there is no inflation danger in Switzerland and a "massive disruption as the collapse of the euro area" the SNB could continue its buying operations for a prolonged time.

Data as of August 7 show that the deflation in Switzerland actually continues although at a slower pace, despite the increase in the money supply. The country's consumer price index (YoY basis) value for July is -0.7% (down from -1.1% for June). So generally for now inflation is not a problem and the SNB has more room to go defending the floor before it could be forced to take additional measures.

Concerning the "collapse of the euro area" my article on the possibility of a trend reversal in the EURUSD pair mentions the recent remarks of Mr. Draghi on the irreversibility of the euro and the legitimate hurdles in front of a country who would like to leave the euro zone once it got in there. While politicians could be surprising people the recent rhetoric and consecutive actions of the ECB combined with some expected events on the other side of the ocean have the potential to start a near- to long-term appreciation of the euro against the U.S. dollar. Such a general trend would lead to appreciation of the euro against the Swiss franc also. An appreciation of this king would allow the SNB to better diversify its foreign reserves as it could sell euro on the way up, both for USD and CHF. Although selling from a player of this size could limit the upside potential of the euro, such a sell would lower again the bank's exposure to foreign currencies and prepare it better for another possible future defense of the peg.

A change in the general trend of the euro against the USD could provide the mentioned possible profit opportunity in the EURCHF pair. If such an uptrend of the euro occurs the correlations could gradually change and get closer to the ones the pairs exhibited before the peg was introduced.

In order to protect their investments in the currency markets a recommended practice for the participants is to place stop loss orders. A relatively tight stop below the peg level could provide protection of the invested capital. That way even if the peg doesn't hold at some point, the stop should limit the possible losses.

In general entering the market could be done directly by some of the many retail forex brokers or via any of the available currency ETFs. Unfortunately an ETF that tracks the value of the Swiss franc against the euro is not currently available so the negative correlation advantage of the pair to a portfolio could not be achieved via an ETF.

In order to gain exposure to any uptrend in the EURUSD pair one could use the CurrencyShares Euro Currency Trust (NYSEARCA:FXE). This ETF measures the relative value between the U.S. dollar and the euro. The fund is euro denominated and has an expense ratio of .40%.

Other options are a short position in the DB USD Index Bullish (NYSEARCA:UUP) or a long one in the DB USD Index Bearish (NYSEARCA:UDN). Both funds have an expense ratio of .50% and they try to replicate a position, long or short respectively, in the U.S. dollar against six major currencies, including the euro (57.6%), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish Krona (4.2%) and Swiss franc (3.6%).

Anyone entering the currency market should be aware of the high volatility it generally presents. Thus it might not be suitable for all investors. Investors are required to make their own due diligence and/or consult a professional adviser before executing any trades.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I'm long EUR against the CHF.

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