ForexSpirit

I have been keeping an eye on the various discussions of FreedomRocks around the web. I have already given a pretty in-depth explanation of the type of strategy that FreedomRocks is using in my correlations post.

I explained that the FreedomRocks strategy is not a pure hedging method. Instead it provides a hedge against moves in the US dollar, but not in the other currency pairs used.

In my net travels I came across a rather interesting discussion on what is a true hedge of all currencies involved. This method is known as The Impeccable Hedge. If you are at all interested in FreedomRocks or currency correlations in general the linked discussion is well worth a read. It has also been called Triangular Arbitrage.

If I use the currecy pairs from my original example in the correlations post, which are EUR-USD and USD-CHF, we end up being able to hedge out any effect from the US dollar. Adding in the resulting cross rate of EUR-CHF, it is possible to open a trade in all three currency pairs so that your resulting exposure is zero. All three currencies can move up or down, it won’t make any difference to your account equity. You are completely hedged.

The trick is now trying to figure out a way to make some money from this impeccable hedge. The markets are not totally efficient all the time. When market participants are the ones to avail themselves of these small discrepancies in the markets it is known as arbitration. Arbitration will remove any inequalities in the pairs being used.

The strategy proposed in the Impeccable Hedge thread on the kreslik.com forum is an arbitration strategy. It is possible to calculate the inefficiencies between the three pairs; the hard part is in taking advantage of the ineffiency. You need to be able to guarantee that you can enter all three trades simultaneously. If one trade is out then your position is ruined. No current retail broker offers such a feature, and I doubt they will any time in the near future. The second hurdle is being able to make enough profit from the inefficiency to be able to cover the costs of the trades, including the spreads on the trades taken and any commission costs incurred.

Such currency arbration will remain in the domain of hedge funds and other large financial institutions for the foreseeable future.