Pair Trades

Pair trading is a popular currency trading strategy. It gives us the opportunity to capture a dislocation between two currencies by taking a long position in one currency and a short position in another currency simultaneously in equal dollar amounts. In identifying a good pair trade, one would have to look for two currencies that share the same characteristics that have a strong historical statistical correlation in order to minimize the losses.

I found two pairs of currencies for one to work on beginning of this year.

First, intra-Europe regional – the paths of the Euro and the British Pound, which have diverged in recent months due to the under-performance of the UK economy relative to that of the Eurozone. My argument is that the Euro could be vulnerable to a sharper decline and the culprit will be the sovereign debt problems in the region. Greece has been downgraded by all three rating agencies on concerns of the ability to service its sovereign debt. Now Portugal, Spain, Italy and Ireland are all under the microscope for similar reasons. I think we will see both currencies Euro vs USD and British Pound vs USD to move lower but the euro will likely fall faster as the issues with Greece and other weak spots in the Eurozone continue to unfold. I am looking for the Euro to weaken against the pound, bringing the spread back together.

Secondly, intra-Asia currencies play between Japanese and Korean Won against the USD. Japanese Yen has been the best performing currency in the past two and half years while other Asian currencies were crushed during the height of uncertainty. That in turn caused a divergence between the Japanese Yen and other Asian currencies, especially the Korean Won.

This was driven by the forced unwinding of the yen carry trade. In other words, the huge interest rate gap between the Japan and the rest of the world drove investors to borrow massive amounts of yen for virtually free, exchanging it for higher yielding currencies around the world. But the sour economic conditions in Japan and attempts to fight record deflation with more stimulus is beginning to weigh on the yen. Meanwhile, South Korea’s economy has fared far better on a relative basis and this makes a convergence between these two currencies likely and offers the potential for a profitable pair trade.