ForexGen | Hedging One Forex Pair with Another

While the Dollar rally may ultimately prove beneficial to US consumers (due to cheaper imports), it is certainly not helping US-based multinational corporations. Companies that earn a significant portion of their revenue abroad would normally be considered stable investments during times of economic uncertainty, since their exposure to individual economies is minimal. In the context of the current crisis, however, such companies have struggled; since they must report earnings in terms of USD, a strong Dollar is equivalent to lower earnings on foreign sales. Some companies have turned to hedging their exposure, while others have opted to either ride out the fluctuations and/or hope that they cancel each other out, banking on the notion that forex is ultimately a zero-sum game. Dow Jones reports:

To be sure, such global currency fluctuations are hard to manage and even those companies that do have hedges in place may only be able to limit and not completely offset the pressures of a strengthening greenback and oscillating exchange rates.
December 19, 2007
The hedging topic often comes up in forex forums. One recent example was a trader who likes to trade GBP/JPY in what is basically a carry strategy. In order to protect his downside, he hedges his position with a short in CHF/JPY. The two are fairly highly correlated, so that would seem to be a good hedge. In theory, it is. There’s a bit of a snag in it all, though.
Firstly, when you hedge you need to match position values. Since a lot of GBP/JPY has a higher value than CHF/JPY - remember you are buying or selling the first (base) currency - you need to actually sell more than a single lot of CHF/JPY to accomplish a full value hedge. The GBP/CHF exchange rate is currently about 2.3, meaning you would need to sell about 2.3 lots of CHF/JPY for each GBP/JPY you go long.

Here’s the catch, though. If you do that full value hedge, you actually end up creating a completely different exposure in your account. When you match a long GBP/JPY with an equal value of CHF/JPY you end up completely cancelling out your JPY exposure by going long and short equal amounts of that currency. That leaves you with a long GBP/CHF position, which obviously has completely different price action characteristics.
Of course you could then short GBP/CHF to totally nullify your risk all together. There’s not much point of that, though. In doing so you would lose your ability to gain on any type of price movement, would end up with a net loss because of the spread doing all those trades, and would probably be in a negative carry position (or at best neutral).
This is why it’s important to understand the implications to your net overall exposure when you trade multiple forex pairs, for hedging or otherwise.

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