FOREIGN EXCHANGERON SCHELLINGRon Schelling, private trader,reviews and discusses the <strong>FX</strong>-<strong>Quant</strong>trading system using quantitativeanalyses on Forex marketsForex Arbitrage Usingthe Currency BasketMARCH 2007 / VOLUME 3 ISSUE 357
FOREIGN EXCHANGEWhat does Arbitrage mean?Arbitrage is a financial operation in whichcurrency pairs are bought and sold, eithersimultaneously or in a minimum lapseof time, either in the same market or adifferent one, with the goal of obtaininga profit spread – a product of the rate’sprice differentials. Arbitrage, in its purestform, is defined as the purchase of securitieson one market for immediate resaleon another market in order to profit froma price discrepancy. This results in immediaterisk-free profit.Arbitrage, however, can take other formsas well. Unlike pure arbitrage, statisticalarbitrage (also called a pair trade or spreadtrade) does involve risk. Despite the disadvantagesin pure index arbitrage, statisticalarbitrage is still accessible to mostretail traders. Although this type of arbitragerequires taking on some risk, it isgenerally considered “playing the odds”.What is an Arbitrage Model?Arbitrage models for currency/stock pairsmay be designed in a variety of ways. Theimportant key is to have knowledge of therelationships among pairs.Statistical Arbitrage (Pairs)Trading SystemsIt is rarely in the best interests of investmentbankers and hedge fund managersto share profitable trading strategies withthe public, so the arbitrage remained asecret of the professionals and a few deftindividuals.Statistical Arbitrage: PairsTradingThis form of arbitrage relies on a strongcorrelation between two related securities.Pairs trading has the potential toachieve profits through simple and relativelylow-risk positions. The pairs tradeis market-neutral, meaning the directionof the overall market does not affect itswin or loss.What Is “Market-Neutral”?A market neutral strategy is one where atrader takes a long position and a shortposition at the same time. There are manyways of implementing this strategy butthe basic premise is the same: at any giventime some securities are overvalued andothers are undervalued. Once two marketsdetermined to be statistically “outof alignment”, a long position is taken inthe market considered to be undervaluedwhile a short position is simultaneouslytaken in the market considered to beovervalued relative to the first market.In this <strong>article</strong> I like to take a next step,review and discuss the <strong>FX</strong>-<strong>Quant</strong> tradingsystem using quantitative analyses on Forexmarkets.With most trading systems, monthly returnsare uncorrelated, i.e. a series of losingmonths does not improve the chancesfor profit in the coming months. With <strong>FX</strong><strong>Quant</strong>’s system, however, the losses makeground for future gains.Numerical simulations show that in longrun, and if reasonable leverage is used, theprofit factor of this system will be greaterthan unity (the sum of gains will alwaysbe greater than the sum of losses). Theleverage is carefully determined in orderto avoid disastrous draw downs.The objective is to achieve capital appreciationwith controlled draw downs. Thissophisticated and innovative methodologyis viable investment alternative forboth private and institutional investors,especially in today’s chaotic markets.It took some time within investmentcircles for currency to be recognized assomething where you can consistently addvalue. In currency markets, because whereverthere is a buyer there is a seller, manyhave said currency markets are a zero-sumgame. Also, as the currency market is themost liquid and largest financial marketin the world, it is a big ocean to feed in.This allows opportunities for our systemto extract value from inefficiencies in thecurrency markets and generate positivereturns.The <strong>FX</strong> <strong>Quant</strong>’s trading strategy is basedon quantitative analysis - a statistical concept.It is 50% statistical arbitrage statisticaland 50% position size management.Unlike most trading systems, which attemptto predict market direction, thistrading model reacts to price action andmakes trading decisions.Figure 1 – The StrategyDiversificationThe strategy creates a complex portfolioof 10 global currencies and adjusts itscomponents daily. The mathematics ofportfolio diversification show that whenyou combine weakly correlated currencypairs together, a higher information ratio(returns per unit of risk) is generatedthan with individual currencies. In otherwords, diversification of currencies canlead to better risk-rewards for the combinedportfolio.As an example, in a portfolio comprisedof three currency pairs, one position canbe unprofitable at the moment, but theother two can show profits to more thancompensate for the losses incurred withthe losing one.The system works with all currency pairs.The system is non-parametric, i.e. thereare no parameters to optimize, except theleverage. Hence, the system is very robustand does not depend on price patterns(which most trading systems depend on).The leverage is carefully determined in orderto avoid disastrous draw downs.Standard risk parameters employ an averagecombined leverage around 2.5:1 forthe entire portfolio. The historical maximumleverage was 5.9:1 and it lasted forless than 2 months. An important systemfeature is that leverage reverts/oscillatesaround a long term average. The best timeto start trading is when the actual leverageis above the average (long term) leverage.The leverage and the estimated riskis reported in the monthly performancereports.58 MARCH 2007 / VOLUME 3 ISSUE 3
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