In the dynamic world of cryptocurrency trading, dual currency perpetual contracts—often referred to as Quanto contracts—present unique challenges and opportunities. These instruments allow traders to speculate on the price of one cryptocurrency while their profit and loss are settled in another, typically Bitcoin (XBT). This structure introduces complex correlation risks between the two assets involved. This guide breaks down the hedging process from first principles and provides actionable strategies to manage these risks effectively.
Understanding Dual Currency Perpetual Contracts
Dual currency perpetual contracts are futures contracts without an expiry date. They are quoted and margined in one currency (e.g., XBT) but track the price of another asset (e.g., ETH). This creates a "Quanto" effect, where the payoff depends not only on the price movement of the underlying asset but also on the exchange rate between the two currencies.
For example, the ETHUSD perpetual contract on many exchanges is settled in XBT. This means that even if you correctly predict the direction of ETH's price movement against the US dollar, your profit or loss in XBT terms can be significantly affected by how XBT itself moves against the dollar.
Core Concepts and Notation
To illustrate the hedging process, let’s define some key variables:
- Contract Symbol: ETHUSD
- Multiplier: 0.000001 XBT
- ETHUSD Price: $500
- .BETH (ETH/USD Spot Index): $500
- .BXBT (XBT/USD Spot Index): $10,000
Scenario 1: Shorting ETHUSD and Hedging
Assume you short 100,000 contracts of ETHUSD.
Step 1: Calculate Position Value
First, determine the value of your position in XBT and ETH terms.
XBT Value = $500 * 0.000001 XBT * -100,000 = -50 XBT
To find the equivalent ETH value, we adjust for the ratio of the two indices:
ETH Value = XBT Value / [ .BETH / .BXBT ] = -50 XBT / (500 / 10,000) = -1,000 ETH
Step 2: Execute the Hedge
You decide to hedge your ETH/USD exposure by purchasing 1,000 ETH at the current spot price, assumed to be equal to the .BETH index price.
At this point, your position is delta-neutral regarding the underlying asset (ETH). However, you are now exposed to the correlation risk between XBT and ETH.
Analyzing Extreme Correlation Moves
The profitability of your hedged position is heavily dependent on the correlation between XBT and ETH.
Example 1: Negative Correlation (.BETH Rises, .BXBT Falls)
- .BETH and ETHUSD rise to $750
- .BXBT falls to $5,000
Calculate P&L:
ETHUSD P&L (in XBT) = (Exit Price - Entry Price) * Multiplier * Contracts = ($750 - $500) * 0.000001 * -100,000 = -25 XBT
Convert this XBT P&L to its USD value using the exit .BXBT price:USD Value of XBT P&L = -25 XBT * $5,000 = -$125,000
ETH Spot P&L (in USD) = (Exit .BETH - Entry .BETH) * ETH Quantity = ($750 - $500) * 1,000 = +$250,000
Net USD P&L: -$125,000 + $250,000 = +$125,000 Profit
In this scenario, the negative correlation (XBT down, ETH up) worked in your favor.
Example 2: Positive Correlation (.BETH Rises, .BXBT Rises)
- .BETH and ETHUSD rise to $750
- .BXBT rises to $15,000
Calculate P&L:
ETHUSD P&L (in XBT) = -25 XBTUSD Value of XBT P&L = -25 XBT * $15,000 = -$375,000
ETH Spot P&L (in USD) = +$250,000
Net USD P&L: -$375,000 + $250,000 = -$125,000 Loss
Here, the strong positive correlation (both assets rising) led to a loss, as the XBT-denominated loss was magnified by the rising value of XBT.
Summary for Short Position: A hedged short position profits when the correlation between the two currencies decreases and incurs losses when the correlation increases.
Scenario 2: Longing ETHUSD and Hedging
Now, assume you go long 100,000 contracts of ETHUSD.
Step 1: Calculate Position Value
XBT Value = $500 * 0.000001 XBT * 100,000 = +50 XBTETH Value = XBT Value / [ .BETH / .BXBT ] = +50 XBT / (500 / 10,000) = +1,000 ETH
Step 2: Execute the Hedge
You hedge by short selling 1,000 ETH at the spot price, ignoring borrowing costs for simplicity. Your position is now delta-neutral.
Analyzing Extreme Correlation Moves
Example 1: Negative Correlation (.BETH Rises, .BXBT Falls)
- .BETH rises to $750
- .BXBT falls to $5,000
ETHUSD P&L (in XBT) = +25 XBT → USD Value: +25 * $5,000 = +$125,000ETH Spot P&L (in USD) = ($750 - $500) * -1,000 = -$250,000
Net USD P&L: +$125,000 - $250,000 = -$125,000 Loss
Negative correlation hurts the hedged long position.
Example 2: Positive Correlation (.BETH Rises, .BXBT Rises)
- .BETH rises to $750
- .BXBT rises to $15,000
ETHUSD P&L (in XBT) = +25 XBT → USD Value: +25 * $15,000 = +$375,000ETH Spot P&L (in USD) = -$250,000
Net USD P&L: +$375,000 - $250,000 = +$125,000 Profit
Positive correlation benefits the hedged long position.
Summary for Long Position: A hedged long position profits when correlation increases and incurs losses when correlation decreases.
Key Takeaways and Strategic Implications
The flat basis between ETHUSD and its .BETH index at entry implicitly assumes zero correlation between XBT and ETH. Your P&L becomes a direct function of how this actual correlation deviates from that assumption.
- Short Hedge: Benefits from falling correlation.
- Long Hedge: Benefits from rising correlation.
The Critical Role of Investment Horizon
Correlation between crypto assets is not static. It can change dramatically based on market regimes, news events, and macroeconomic factors.
- Short-Term Traders (e.g., Market Makers): For those entering and exiting positions rapidly, the Quanto correlation risk is often minimal and can be managed within tight spreads.
- Long-Term Holders: For traders or investors holding positions for extended periods, the impact of changing correlation can be significant enough to determine the overall success or failure of a trade. The longer the holding period, the greater the probability of a meaningful shift in the correlation structure.
Managing Covariance Risk
Sophisticated market makers do not leave this covariance risk unhedged. They actively manage it by continuously rebalancing their exposure. The profitability of this hedging activity depends on the volatility of the two assets and the direction of the correlation move.
- High Volatility: If both XBT and ETH are highly volatile, the gains or losses from the correlation bet are amplified.
- Active Management: Success requires constant monitoring of the covariance and a disciplined strategy to hedge the P&L exposure. 👉 Explore advanced hedging tools
Without extensive historical data, pricing this correlation risk precisely is challenging. As the market matures, analyzing past data will be crucial to determine how much of the funding rate in these contracts compensates for the Quanto risk versus the simple interest rate differential between the two cryptocurrencies.
Frequently Asked Questions
What is a Quanto perpetual contract?
A Quanto perpetual contract is a futures contract with no expiry date where the underlying asset is denominated in one currency (e.g., ETH/USD) but the contract itself is settled in a different currency (e.g., XBT). This introduces correlation risk between the two currencies.
Why is hedging a dual currency contract more complex?
Hedging is complex because you must manage the price risk of the underlying asset and the exchange rate risk between the settlement currency and the asset's denomination currency. A standard delta hedge is not sufficient.
How does correlation affect a hedged short position?
A hedged short position on a Quanto contract (e.g., short ETHUSD, long ETH spot) will be profitable if the correlation between the settlement currency (XBT) and the underlying asset (ETH) decreases. It will be unprofitable if their correlation increases.
What is the main risk for long-term holders of these positions?
The primary risk is that the correlation between the two cryptocurrencies will change over time. Since these contracts have no expiry, the holder is exposed to an unpredictable and potentially significant correlation shift for the entire duration of the trade.
How do market makers typically manage this risk?
Market makers actively manage this covariance risk by frequently re-hedging their exposures. They use sophisticated models to monitor the volatility and correlation between the assets and adjust their portfolios accordingly to minimize unexpected P&L swings.
Can the funding rate compensate for this risk?
The funding rate in perpetual contracts is a mechanism to tether the contract price to the spot index. It primarily reflects the interest rate differential between the two assets. However, a portion of it may also incorporate a risk premium for the Quanto correlation risk, though this is difficult to isolate without historical analysis.