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Let's assume you are based in France but you are a UK citizen. We can say you are mostly concerned about EUR (because you currently live and spend in Eurozone) and GBP (because you might at some point go back to UK to live there). So you are in a situation of uncertainty regarding which currency to see as your base currency. From a trading perspective I can see it makes a lot of sense to trade GBP/EUR (so that you can try at any time to keep your money invested in the currency you expect will be increasing in th next future).

But if you want to trade FX, how would you approach the trading of other currency pairs? So, assume I might want to trade USD/JPY and that I want to allocate to that activity 20,000 EUR. So the equivalent of 20,000 EUR will be dedicated to the trading of USD/JPY.

Even if I am always correct when trading this pair, I am ultimately concerned about its value in terms of EUR and GBP. In other words, I don't want the profits from that trading activity to go down only because the USD or JPY has depreciated against my two candidate base currencies.

What would be the best strategy to trade USD/JPY and still have some protection against depreciations in terms of base currencies?

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  • I bet all the foreign fund manager also looking for the silver bullet answer. IMHO, you can buy those sound foreign stock, though this will also introduce new risk if you are not holding those stock for the long term.
    – mootmoot
    Commented Sep 10, 2019 at 9:03

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Buy the EUR/USD at 1.10380 and that means that 1 euro buys 1.10380 dollars. It also means long-the-euro and short-the-dollar. Now take the reciprocal and 1 dollar buys 0.90596 euros.

Then also buy the USD/JPY at 107.310 and that means that 1 dollar buys 107.310 yen. It also means long-the-dollar and short-the-yen.

Since the pair of transactions represents both short-the-dollar and long-the-dollar the result of the two transactions is long-the-euro and short-the-yen as the buy-side of the EUR/JPY currency pair.

So 0.90596 euros relates to 107.310 yen as 1 euro relates to x . Then x = 107.310 / 0.90596 or 118.449 for the EUR/JPY currency pair.

Now, for instance, a sell-side of the JPY/EUR currency pair would be short-the-yen and long-the-euro.

The EUR/USD currency pair is calculated as the size of the euro position taken and it doesn't matter if the transaction is buy-side or sell-side. The margin amount can be in either currency or in the account currency but basically in the account currency.

The USD/JPY currency pair is calculated as the size of the dollar position taken and it doesn't matter if the transaction is buy-side or sell-side. The margin amount can be in either currency or in the account currency but basically in the account currency.

So it would actually be difficult to equalize the two currency-pair positions unless taking position sizes in between account increments.

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To hedge against currency risk, you can convert your base currency to the trading currency first, then set up a forward exchange contract to convert the trading currency back to your base currency.

The FX forward exchange contract has a known profit/loss, which you can then factor into your trading decisions.

Example

Suppose the current exchange rate is EUR1 = USD1.1 and you are able to enter into a forward exchange rate contract for EUR1 = USD1.1325 that settles in 12 months.

You convert EUR20k to USD22k and enter into a 12-month FX forward contract for the same USD22k to convert to about EUR19,426 (or because you're confident that you'll make a tidy profit on your USD/JPY trades, you enter into a 12-month FX forward contract for USD22,650). If your trading period isn't 12 months, change the period of the FX forward accordingly.

This allows you to hedge away risk that USD has depreciated against EUR by the time your trading period expires. Note that in doing so, you leave yourself exposed to a possible loss on the FX forward if your trading strategy doesn't do as well as you hoped. You can mitigate this by using shorter terms, but the fundamental risk remains. Of course, if your trading strategy succeeds, the profits are unhedged, but FX risk on profits isn't as painful as FX risk on principal.

Disclaimer: This is not to be construed as financial advice. Please consult a financial advisor for financial advice.

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  • The thing is that if I trade USD/JPY, effectively the amount of USD (or JPY) I have converted at the beginning might have changed significantly as part of the realized P&L on my USD/JPY trading activity. How to account for this? Also, how can I trade a forward as a retail customer?
    – opt
    Commented Sep 10, 2019 at 12:00
  • @opt I've added an example to the answer. As for trading forwards as a retail customer, that's something to check with your banks or other trading desks.
    – Lawrence
    Commented Sep 10, 2019 at 14:08

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