A multi-currency hedge takes opposite positions on two positively correlated currency pairs. For example, consider a short position on EUR/USD. To hedge your USD exposure, open a long position on GBP/USD, assuming they have a high correlation. This strategy results in protection from the Euro falling against the US Dollar.
Unlike the direct hedge (short-long) that results in zero net profit, a multi-currency strategy makes it possible that one position might earn more than the other losses.
Since this strategy only involves forex transactions, it is suitable for all investors.
A hedge based on multi-currency can provide better protection than a direct hedge.
Low to Moderate
In terms of cost, this strategy is the same as any other forex transaction.
Using the fictitious correlation table below, find the currency pairs most closely related to EUR/USD.
If you answered EUR/USD with GBP/USD, you are correct. The positive correlation of 0.95 is excellent. This result means that GBP/USD will mirror a move in EUR/USD 95% of the time. One caveat is during the six-month mark, where the correlation dropped to 0.66. However, over one year, the two currency pairs exhibit an obvious correlation.
Since EUR/USD with GBP/USD is highly correlated, an investor taking a long position in GBP/USD can protect against the British Pound dropping by taking a short position in EUR/USD. However, a new risk occurs with the Euro and the Pound.
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.