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Forex Triangular Arbitrage

April 25, 2022 by ForexFunds.com

Triangular arbitrage is a trading concept involving three currencies and the three exchange rates that connect them. The idea is that the three rates should be mathematically consistent with one another; when they briefly are not, a trader could, in principle, exchange money around the triangle and finish with more of the starting currency than the amount first committed, before costs. This article is educational only; it is not investment advice, and nothing here is a recommendation to trade.

The starting point is the cross rate. If two currencies are each quoted against a third, those two quotes imply a rate between them. As a hypothetical illustration, suppose one euro costs 1.20 US dollars and one British pound costs 1.50 US dollars. Dividing the first rate by the second gives an implied cross rate of 0.80 pounds per euro. If the euro-pound rate actually quoted in the market were meaningfully different from that implied figure, the three rates would be briefly inconsistent.

That inconsistency is what the three-trade cycle attempts to capture. A trader would exchange the first currency for the second, the second for the third, and the third back into the first. If the quoted cross rate diverges from the implied one by more than the cost of trading, the cycle ends with a small surplus. The act of trading the cycle also tends to close the gap: the buying and selling pressure pushes the three rates back toward consistency, which is why such discrepancies are self-correcting.

Practice is far less forgiving than arithmetic. The cycle only works if all three rates remain favorable through execution: the trades happen one after another, and each leg is filled at whatever price is actually available at that moment. Bid-ask spreads and fees reduce whatever surplus a quoted discrepancy appears to offer, and if any of the three rates changes between trades, the apparent difference can shrink, disappear, or turn into a loss. A cycle that looked favorable when it was spotted can therefore complete at a loss, and no outcome from attempting it is assured.

The concept is still worth understanding, because it explains why exchange rates rarely drift far from internal consistency: participants watching for these gaps are part of what keeps the three-way arithmetic of currency prices aligned.

Whether any trading concept matters for a particular portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

The related articles on this site cover the Forex market itself, correlation, the Sharpe ratio, and how managed accounts and hedge funds differ.

What is the Forex Market?

January 30, 2022 by ForexFunds.com

The foreign-exchange market, usually shortened to Forex or FX, is the market in which one country’s currency is exchanged for another’s. Trading happens in pairs: buying one currency means selling another, and the exchange rate between the two is the price. Unlike a stock exchange, the Forex market has no single central marketplace; trading takes place over the counter through networks of banks, brokers, and electronic platforms.

Many kinds of participants use this market for different reasons. Businesses exchange currencies to pay for goods and services across borders and to manage the currency risk in their contracts. Banks trade for their clients and for themselves. Governments and central banks participate in connection with their monetary and reserve policies. Investors and speculators trade in an attempt to profit from changes in exchange rates. This article is educational only; it is not investment advice, and nothing here is a recommendation to trade.

The modern market is best understood through its history. For much of the early twentieth century, major currencies were linked to gold, and the United States dollar was convertible to gold at a fixed rate, backed by official gold reserves. After the Second World War, the Bretton Woods framework tied participating currencies to the dollar and established the two Bretton Woods institutions: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). The General Agreement on Tariffs and Trade (GATT), signed in 1947, was not a Bretton Woods institution, but it was envisaged as the trade leg of the same postwar economic architecture. In 1971, the United States suspended the dollar’s convertibility into gold, which effectively marked the end of the fixed-rate framework; a brief attempt to restore fixed parities followed before major currencies moved to floating rates. This is why 1971 is often treated as the beginning of the modern Forex era.

Since then, most major currencies have floated: their values move with supply and demand in international markets rather than by a fixed peg. This is a general description, not a universal rule; some countries continue to peg or manage their currencies, and exchange-rate policy differs by country. Exchange rates respond to many influences, including interest rates, inflation, trade flows, and economic and geopolitical events, and these relationships are neither simple nor stable.

Whether any of this matters for a particular portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

To go deeper, the related articles on this site cover correlation, the Sharpe ratio, managed accounts and hedge funds, and how to think about a manager’s track record.

Forex Funds and Managed Accounts are Popular Alternative Investments.

July 13, 2021 by ForexFunds.com

Forex funds and managed accounts have become popular alternative investments. The term “Alternative Investments” is defined as investment securities trading outside traditional investments like stocks, bonds, cash, or real estate. The alternative investment industry includes:

Hedge funds.
Funds of hedge funds.
Managed futures funds.
Managed accounts.
Other non-traditional asset classes.

They differ in the dimensions that matter. Risk varies by investment, not by label. Liquidity varies: some alternatives trade readily, while others are difficult or slow to sell. Valuation varies: assets that do not trade on public markets can be hard to price, and stated values may rest on estimates. Complexity and fees vary as well, and complex or illiquid products can carry risks that are harder to see in advance.

Correlation deserves particular care. Alternatives are often discussed in connection with diversification because some of them have, at times, moved differently from traditional markets. But correlation is a measured, changing property of specific investments over specific periods, not a fixed attribute of a category. An investment’s past correlation with other markets may not persist, and relationships between markets can shift. Neither the alternative label nor a low correlation measured in the past assures diversification or any particular return.

Whether adding any investment actually diversifies a portfolio depends on the positions the portfolio already holds, their concentrations and correlations, and the strategy being pursued, and all investments involve risk, including the possible loss of the amount invested. How any of this applies to a particular portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

Redemption Provisions for Forex Managed Accounts.

May 25, 2021 by ForexFunds.com

Forex managed accounts and hedge funds typically provide specific redemption frequencies, such as monthly, quarterly, and yearly. They may also require a particular notice period, such as 60, 90, or 180-days. In addition, some Forex managed account programs and hedge funds can stop redemptions once they exceed a certain percentage of the total assets under management in the program. Most Forex manager account programs and hedge funds disclosure documents contain language to the effect that the trading manager may suspend withdrawals if those redemptions put the remaining investors in an unfair position. Trading managers often “lock up” investor’s capital for some time upon the initial investment. These lock-up periods can be “hard,” meaning the investor cannot take any of his money out, or “soft,” meaning the investor can take a percentage of his total assets under management out of the fund or managed account program.

Redemption provisions are an essential part of a Forex managed account program. It important for the investor to read the Forex funds or managed account program’s disclosure documents so he is not surprised when he attempts to withdraw his funds from the trading account.

What Is The Difference Between A Hedge Fund and a Managed Account.

March 3, 2021 by ForexFunds.com Leave a Comment

Forex hedge funds and managed accounts are two structures through which an investor may delegate foreign-exchange trading to a professional manager. They can pursue similar strategies, but they are organized differently, and the differences matter. This article is educational only; it is not investment advice, legal advice, or tax advice, and nothing here is a recommendation of either structure.

The core difference is ownership. A hedge fund is a pooled vehicle: investors contribute capital and receive an interest in the fund itself, and it is the fund, not the individual investor, that owns the underlying positions. A managed account is the opposite arrangement: the account is opened in the investor’s own name, the investor owns what is in it, and the investor may grant a manager authority to make trades in it. The scope of that authority, and how it is granted and revoked, depend on the exact account and management agreements.

Ownership drives custody and control. In a pooled fund, decisions about the portfolio, and the terms for contributing or withdrawing capital, are governed by the fund’s offering and governing documents. In a managed account, the assets remain in the investor’s account; any right or process to change or revoke trading authority is governed by the account and management agreements. In both cases, the actual rights an investor holds are defined by the specific documents signed, not by the label on the structure.

Transparency and fees follow the same pattern. A managed account gives the investor direct visibility into the account’s positions and activity, subject to the arrangements with the broker and manager. A fund reports to its investors in the manner its documents prescribe. Fee arrangements exist in both structures and vary; what an investor actually pays is set by the governing documents or the management agreement, and should be read there rather than assumed.

Hedge funds are often associated with techniques such as leverage, short positions, and derivatives. Whether a particular fund may use them is defined by its own documents, and a managed account’s permitted strategy is likewise defined by its agreement. These techniques can magnify losses as well as gains. Neither structure, by itself, produces better performance or lower risk than the other; outcomes depend on the strategy, the manager, the costs, and the markets.

The two structures organize exposure differently, but neither label establishes diversification. Whether a portfolio is diversified depends on the actual positions held, their concentrations and correlations, the strategy pursued, and the rest of the investor’s portfolio, not on whether the vehicle is a fund or an account. How either structure fits a portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

Related articles on this site cover the Forex market, correlation, the Sharpe ratio, and how to evaluate a manager’s track record.

Forex Managed Account Program Disclosure Document

September 22, 2018 by ForexFunds.com Leave a Comment

A disclosure document is the document through which a managed-account program describes itself to prospective investors. Whether a particular program provides one, and what it must contain, depends on the jurisdiction, the program’s structure, and the manager’s registration status or exemptions, so this article describes what a prospective investor can look for where such a document is provided. It is educational only; it is not investment advice or legal advice, and nothing here is a statement of what any particular manager is required to do.

Where a disclosure document is provided, several subjects are worth reading closely. The identity and background of the manager and the program: who is trading, and what experience and business history they describe. The strategy and the markets: what is traded, in which instruments, and with what approach. The material risks: the document’s own description of what can go wrong, which deserves at least as much attention as anything else in it.

Fees and expenses are a further subject: what the manager charges, what other costs the account bears, and how those charges are calculated. So is the presentation of performance, where one exists: the basis on which figures are calculated, whether they are actual or hypothetical, and the limitations the document itself places on them. Past performance is not indicative of future results, and a presentation that does not explain its own basis is difficult to evaluate.

Conflicts of interest, the service providers involved, the scope of the trading authority the investor grants, and the terms for withdrawals and termination, where applicable, round out the reading. In every case the governing language is in the exact documents themselves; a summary, including this one, is not a substitute for them.

Two habits serve a prospective reader well. First, if something material seems missing or unclear, ask the manager and expect a clear answer. Second, treat claims that cannot be verified from the documents with caution, and take time with the written risk disclosures rather than treating them as a formality.

Whether any program fits a particular portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

Related articles on this site cover the Forex market, managed accounts and hedge funds, notional funding, and how to evaluate a manager’s track record.