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29 August 2012
Introduction to Foreign Exchange
Global FX Strategy John Normand
(44-20) 7134-1816 email@example.com J.P. Morgan Securities plc
John Normand Managing Director Head, Global FX Strategy +44 20 7134 1816 firstname.lastname@example.org See page 3 for analyst certification and important disclosures. www.morganmarkets.com/GlobalFXStrategy
Foreign exchange is certainly the largest and probably the most misunderstood financial market in the world. Daily trading volumes in FX across all products total some $4 trillion, which is more than five times that of equities. Currency exposure is unavoidable for global investors and corporates, since cross-border activity usually requires a forex transaction. Currency markets can also be highly politicised, since some governments consider FX levels and volatility components of their macroeconomic and industrial policy. Yet despite the currency markets’ size, scope and policy dimensions, they remain enigmatic to many. Academics claim that currency movements are random, which implies that forecasting and trading are futile pursuits. Many investors and risk managers agree with their conclusion, so either ignore currency fluctuations, which leaves them exposed to considerable short-term volatility, or routinely hedge all exposure, which can incur high operational costs and forgo profit opportunities. Both the academic literature and common hedging practices obscure the reality that currencies do observe some core macroeconomic principles, that their movements can be modelled and that their patterns have been exploited profitably by investors and hedgers for years. This handbook , originally written for J.P. Morgan’s Analyst Training Program, integrates the conventional wisdom on currencies with best practice on currency overlay and hedging policy developed by J.P. Morgan Global FX Strategy over the past decade. The goal is to address the questions most frequently asked by institutional and corporate clients rather than to cover dealing mechanics treated in standard texts. Five sections cover (1) size, structure and management of global currency markets; (2) fundamental drivers of exchange rates; (3) modelling and forecasting exchange rates; (4) common trading strategies for investors; and (5) managing FX hedge ratios for investors and corporates. Appendices outline several J.P. Morgan currency indices for spot and volatility; detail liquidity statistics across products; and provide timelines for major events in the currency markets during the post-Bretton Woods era (since 1971). Throughout the presentation are references to the historical evolution of the international monetary system since many of the policy issues driving currencies now have been recurring themes in global currency markets over the past several decades.
Forex markets are unique from four perspectives. They are the most liquid in the world; they trade continuously from Sunday 20:15GMT (when Auckland opens) to Friday 22:00GMT (when New York closes); transactions are largely overthe-counter; and they can be heavily managed through government intervention, particularly in the emerging markets. Daily forex turnover across all products – spot, forwards, FX swaps and options – averages $4 trillion (chart one), the majority of which is spot (37%) and FX swaps (44%). Even daily spot volumes ($1.5trn) dwarf equity market turnover, which totals less than $250bn for cash and futures trading of the world’s five largest equity markets (S&P500, Nasdaq, Nikkei, FSTE and DAX). Over the past decade total turnover has more than tripled from $1.2trn to almost $4trn, with much greater increases in spot (+280%), forwards (+280%) and options (245%) than in swaps (+170%). Major currencies (USD, EUR, JPY, GBP) account for more than 75% of global volumes, but the growth rate of emerging market currency volumes over the past decade has been explosive (>25% annual increases in some markets). London has always dominated global trading and now accounts for 37% of global volumes (chart two). Turnover in New York is half that amount (18%), followed by Tokyo (6%), Singapore, Hong Kong, Switzerland (each 5%) and Sydney (4%).
Though FX remains the most liquid market in the world, its depth has been diminishing over the past two years for the same reasons as in other markets -- rising regulation (which increases capital requirements), a mediocre global economic expansion (which reduces risk-taking and cross-border trade/capital flows) and policy uncertainty from the EMU debt crisis and US fiscal cliff (which discourages investment). To illustrate diminishing cross-border activity post-Lehman, the first chart highlights the stagnation in global exports over the past year and the second shows the plunge in cross-border M&A. International portfolio investment has also declined over the past year, though the downtrend is not as dramatic as with M&A. How these forces impact liquidity is harder to determine in FX than in other markets since most FX trading is over-thecounter and since the most comprehensive survey of global FX activity – the Bank for International Settlements’ Triennial Central Bank Survey - will not be conducted again until 2013. The second-best alternative is the collection of semi-annual survey sconducted by the Foreign Exchange Market Committee operating under central bank sponsorship in the UK, US, Australia, Canada and Singapore (Japan’s FX committee only surveys market participants annually). Previous J.P. Morgan research has found that daily FX futures volumes on the Chicago Mercantile Exchange (CME) closely track this lower-frequency survey data even though futures activity equals less than 10% of OTC spot and forwards trading (see is FX liquidity abnormally low? , Normand, April 4, 2012). Thus daily futures data can approximate real-time volume trends. As shown in the second chart, FX volumes have been contracting over the past year as cross-border activity has declined. Based on a simple econometric model linking global FX volumes to global economic activity (measured by J.P. Morgan’s global PMI index) and European sovereign spreads (as a proxy for uncertainty created by the sovereign crisis), we construct two scenarios for volume growth. A global stagnation scenario (2% global GDP growth, 150bp wider peripheral spreads) implies almost no pick up in FX volumes this year (2% rise in turnover across products), which would mark the slowest pace outside of the Lehman crisis. Conversely, a global stability scenario (3% global GDP growth, 100bp narrower spreads) implies annual volume growth in all FX products of about 12%, so still below the long-run average but much better than the current pace.
Currency markets are disproportionately dollar-centric, whether judged by transaction or investment demand. The dollar is involved in 85% of FX transactions (chart 1), and it constitutes over 60% of the world’s foreign exchange reserves (chart 3). Although the US economy’s size and the depth of its asset markets should create unrivalled demand for dollars for trade and investment, the dollar’s role is disproportionate. The US accounts for only 25% of the global economy and its bond market only 25% of the global government bonds outstanding, yet turnover in the dollar is 20% higher than would be predicted by the size of the US economy (chart 2). Appendix tables 1 and 2 list average daily turnover globally for spot and options markets by currency, to highlight the dollar’s dominance. Note that the Chinese renminbi is grossly underrepresented in global markets relative to the size of the Chinese economy. Turnover should be closer to $350bn per day rather than the $48bn reported. This is largely due to restrictions on internationalisation of the renminbi and capital controls which are easing slowly. Dollar centrism has been deliberate feature of the international monetary system. From 1944 until 1971, the dollar was the anchor currency for the Bretton Woods system which pegged all currencies to the dollar and fixed the dollar to gold at a rate of $35/oz. Under the agreement, the US pledged to exchange its currency for gold at the agreed rate, and other countries agreed to keep their currencies within 1% bands around fixed parities through interventions, restraints on financial flows or compatible monetary policies. When faced with a transitory balance of payments problem, a country could borrow from the IMF to finance intervention rather than institute deflationary macroeconomic programs (such as peripheral Europe is pursuing now within EMU). That system prevailed until August 1971 when a US balance of payments crisis triggered by a growing fiscal deficit and rising inflation prompted a series of mini-USD devaluations and an eventual shift to freely-floating exchange rates for the major economies by March 1973. Even during the floating rate era, however, the dollar has remained the world’s global currency due to lack of alternatives and investment/trading inertia. Recall that the US had no rivals as a singlecurrency investment region until the Euro area’s formation in 1999, and it had only two rivals in global trade (Japan and Germany) until China’s WTO entry in 2001.
Even after Bretton Woods collapsed, many countries maintained hard pegs, crawling pegs or managed floats against the dollar to anchor inflation or maintain export competitiveness. Most Gulf economies have pegged their currencies to the dollar since the mid-1980s, though Kuwait repegged to a basket in 2007. In Latin America, Mexico maintained a crawling peg until 1994, Brazil a crawling peg until 1999 and Argentina a currency board until 2002. Venezuela still pegs to the dollar. In CEEMEA, Russia maintained a crawling peg until 1998 and Turkey until 2001. Emerging Asia’s dollar focus has been the most pronounced over the past decade, even though these currencies are now officially floating. China pegged the renminbi to the dollar from 1994 to 2005, and even once the PBoC floated the currency, it still maintained daily fluctuation limits (now +/- 1% versus the daily fixing) which resulted in unprecedented reserve accumulation of $3 billion over the past decade. The rest of the region mimicked China’s policies despite having floated their currencies during the Asia Crisis. Collectively EM Asia ex-China (Korea, India, Hong Kong, Singapore, Malaysia, Indonesia, Philippines) amassed some $1.3 trillion in reserves over the past decade (see Appendix table 3), thus perpetuating an unofficial, managed exchange rate system known as Bretton Woods II.
The dollar’s dominance has been declining over the past decade but only glacially. In terms of transactional demand, the dollar’s share of total forex turnover (slide 3 chart 1) has only fallen by five percentage points in a decade, from 90% in 2001 to 85% in 2010. Its role as a reserve currency has been declining more sharply but remains dominant. A reserve currency is any medium in which central banks hold their foreign assets. In theory reserves can be any asset which satisfy three criteria: liquid (freely transacted without moving the price); convertible (no government restrictions on buying or selling); and stable (it retains its purchasing power over time). Sterling was the world’s currency in the 19th century in line with the British Empire’s dominance, though now sterling is used in only 13% of global currency transactions (slide 3 chart 1) and constitutes only 4% of global foreign exchange reserves. Gold is the alternative to fiat currencies as a reserve asset and indeed anchored the global monetary system from 1870 to 1914. Under the gold standard, central banks pegged their currencies to bullion at a fixed rate and held gold as official reserves. Most countries scrapped their gold pegs during World War I to facilitate money printing, although many countries tried unsuccessfully to re-peg to gold during the inter-war years (1918 to 1944). The dollar was the world’s de jure reserve currency until Bretton Woods collapsed in 1973, and has been the de facto reserve currency since for the reasons mentioned earlier – the depth of US financial markets and the US’s dominance in international trade. Incumbency helped too, given the considerable transaction costs over the short term associated with shifting reserves and re-invoicing trade. Over the longer term these issues are less material, and those costs probably pale relative to the capital loss from a dollar which has declined 27% trade-weighted over the past decade. From a liquidity perspective the euro is the dollar’s only near-term rival, which is why the dollar’s share in global reserves has fallen from 71% in 1999 to 62% today, while the euro’s has risen from 18% to 25% (chart 1). The yen’s share has been erratic, falling from 6% to 3% in the first half of the last decade but has risen slightly to 3.5% over the past three years. The more notable trend has been in reallocation into non-G4 currencies, bother major (AUD, NZD, CAD, CHF and Scandinavia) and emerging markets. Allocations to non-G4 currencies has doubled over the past year from 2% to almost 5%, largely due to concerns over credit quality/sovereign risk in the G4 (chart 2). Unfortunately this allocation to non-G4 currencies has little diversification value since commodity and emerging market currencies are pro-cyclical. So while holding the currencies of higher-quality sovereigns may raise absolute returns over the long-term, doing so has not raised risk-adjusted returns because these pairs embed higher volatility into the portfolio. Only an allocation to the yen, which is counter-cyclical, s an effective portfolio hedge (see Reserve diversification without the yen has limited value, Normand, Sept 20, 2011).
How long before the renminbi rivals the dollar or the euro? The questions should be phrased more broadly as how does the world create more reserve assets. As noted on slide 7, reserve assets can be any currency which is liquid, convertible and stable. Many currencies are convertible and retain value over time, but few offer sufficient liquidity to accommodate the world’s largest central banks and sovereign wealth funds. Liquidity is relative: a market which is deep enough for a central bank with $50bn in reserves may not be deep enough for a central bank with $250bn of reserves. The FX turnover statistics on slide 3 and in appendix table 1 provide one perspective on liquidity by currency. An additional measure is the size of government bond markets, since bonds constitute the largest share of a reserve manager’s asset allocation. The US, Euro area and Japanese bond markets are the deepest, with close to $5trn in outstanding debt. The UK is fourth, with outstandings of $1.1trn (first chart). Only four other bond markets offer outstandings exceeding $250bn: China ($380bn), Canada ($350bn), Korea ($260bn) and India ($250bn). Other AAA sovereign bonds markets in the G-10 (Sweden, Denmark) offer debt of only $100bn, thus limiting their diversification value for the world’s largest reserve managers. Appendix table 3 and chart 3 on this slide show the world’s largest holders of foreign exchange reserves. Ten countries hold forex reserves exceeding $250bn: China ($3.2trn), Japan ($1.2trn), Saudi Arabia ($570bn), Russia ($510bn), Taiwan ($390bn), Brazil ($370bn), Norway ($350bn), Switzerland ($315bn), Korea ($310bn), Hong Kong ($295bn) and India ($260bn). For managers with such large reserve bases, it is nearly impossible to diversify away from USD, EUR and JPY into higher-quality sovereign bond markets without becoming a price maker. For example, a fund with assets of $200bn looking to move 25% of their assets from USD, EUR, JPY or GBP into the bond market of a country with more stable fiscal policy would need to buy over $50bn of assets. That sum would represent about 14% of the Canadian bond market, 35% of the Australian bond market or 55% of the Swedish bond market, an allocation which would impact bond prices too materially to be worth executing. Thus diversification is near impossible to achieve for reserve managers with an asset base exceeding $200bn, as illustrated by a simple example. If a manager holds two investment objectives – diversification, defined as holding no more than 25% of the portfolio in one currency, and liquidity, defined as owning no more than 10% of a bond market – then they would be unable to invest in any bond market with less than $500bn outstanding (25%*$200bn = $50bn, and $50bn/10% = $500bn). How to resolve the big fish, small pond problem? It cannot be: liquidity, diversification and AAA credit quality are irreconcilable in an era of unprecedented G-10 fiscal deficits.
Over the next few decades, however, the dollar and euro will have more rivals. The tables above track four indicators for monitoring the rise and fall of the world’s reserve currencies: (1) central banks’ current allocation of their FX reserves as measured by the IMF’s quarterly COFER survey, which proxies investment demand; (2) the distribution of global foreign exchange turnover reported in the BIS’s triennial survey, which measures transaction demand;(3) size of the government bond market, which measures a currency’s investment suitability for large reserve holders; and (4) share of world exports, which measures potential transaction demand due to trade invoicing. By allocation of FX reserves, no currency rivals the euro, which is the only challenger to the dollar. Although the IMF aggregates all minor currencies (those other than USD, EUR, GBP, JPY and CHF) into the “other category”, collectively these currencies’ share of global reserves has risen only from 4.8% in 1998 to 5.3% in 2010. By the distribution of global FX turnover, even the euro has made limited inroads against the dollar. According to the most recent BIS survey in 2010, the dollar is used in 85% of forex transactions only, down from 87% in 1998. The euro is used in 39% (up from 38% when the single currency was launched), and the renminbi only in 1% (less than SGD, NOK, AUD and CAD). By size of the government bond market, only Treasuries, JGBs, Euro govies and gilts can accommodate reserve holders with assets in excess of $200bn following the (admittedly arbitrary) liquidity rule proposed on the previous slide that holding no more than 25% of ones assets in a single currency and owning no more than 10% of a country’s bond market requires an investable pool of assets of at least $500bn (25%*$200 = $50bn and $50bn/10% = $500bn). Bond markets in Canada, Australia and China with roughly $300bn outstanding would require a reserve holder with $200bn of assets to own roughly 7% of outstanding bonds if they shifted 10% of their currency allocation into CAD, AUD or CNY. By share of world exports, which may serve as a precursor to invoicing and then transaction demand for a currency, China’s potential global currency status is quite evident. China’s share of global exports has risen from 3% in 1998 (preWTO entry) to 11% in 2011 at the expense of the major economies. The US’s share of world exports has fallen from 13% in 1998 to 9%, the Euro area’s from 16% to 14%, the UK’s from 5% to 3% and Japan’s from 7% to 5%. Amongst the major economies, only Australia’s share of world exports has grown though only from 1% to 2% over the decade.
Judged by the previous four metrics, the renminbi is at least a decade from becoming a major reserve asset even though China’s role in global trade offers it a clear liquidity advantage over minor reserve currencies such as AUD and CAD. For the moment, however, the renminbi role is more potential than actual. As discussed on slide 3 and highlighted again here in chart 1, the renminbi is grossly underrepresented in global foreign exchange turnover. This is largely due to restrictions on internationalisation of the renminbi which limit the use of the currency for trade settlement, and to capital controls. There are no statistics on reserve holdings of renminbi, but these are probably trivial relative to global wealth. Until 2010, CNY was only accessible as a non-deliverable currency, which means investors take exposure through a USD-settled forward whose value is linked to USD/CNY’s value at a future date. The launch of CNH, which is deliverable renminbi trade offshore in Hong Kong (chart 2), now provides a vehicle for taking direct exposure to the currency. Certainly the renminbi is on the path towards reserve currency status and becoming a currency for global trade. The uncertainty centres on the timeline. China has taken several steps to raise the renmindi’s role in international trade and finance. In terms of offshore trade settlement, the authorities allow Hong Kong-registered companies to accept renminbi rather than dollars for payment. For offshore investment, yuan-denominated savings accounts exist in Hong Kong. And foreign companies can issue renminbi-denominated bonds (dim sum bonds). The currency has been convertible on the current account since 1996, and the most recent (2010) Five-year Plan called for gradual convertibility on the capital account. There are, of course, several preconditions for this, such as a strong domestic banking system (to avoid massive capital outflows or overborrowing from abroad as exchange controls are loosened; developed domestic financial markets (to allow corporates and investors to hedge exchange risk; and an equilibrium exchange rate (to avoid destabilising capital flows if the currency is grossly misaligned).
Since the renminbi’s ascent requires decades, some have suggested that the IMF’s Special Drawing Rights (SDR) fill the gap. This synthetic asset will not resolve the problem of inadequate reserve diversification, however. The SDR is an international reserve asset created by the IMF in 1969 to supplement members’ existing reserves under Bretton Woods. The SDR is not a currency; it is a claim on freely usable currencies of IMF members, similar to a swap. Holders can exchange these units into major currencies through an intergovernmental market, and issuers of those currencies could supply them through their reserve accounts or by issuing domestic money. Countries could then sterilise that issuance by simultaneously selling bonds in the domestic money market, thus leaving the money supply unchanged but altering the composition of the central bank’s balance sheet (fewer foreign asset, more domestic assets). The SDRs value was initially set at 0.89 grams of gold, which at the time was equivalent to one US dollar. After Bretton Wood’s collapse in 1973, however, the SDR was redefined as a basket of currencies now comprising USD, EUR, JPY and GBP. The basket is reweighted every five years (next review in 2015) based on a country’s total trade and the value of global forex reserves held in its currency. Since the US dominates both categories, the dollar’s weight dominates -- 41.9% in the December 2010 review (down from 44% in 2005), followed by the euro (37.4%, previously 34%), sterling (11.3%, previously 11%) and yen (9.4%, previously 11%). Being a basket currency, the SDR’s performance is unsurprisingly similar to that of the DXY (chart 2). Clearly many other currencies would qualify for inclusion if they were convertible, since the world’s ten largest trading nations would also include China, Korea, Canada, Russia, Singapore and Hong Kong. This is the rub for expanding the SDR basket to emerging market currencies: those markets are not fully convertible. Even if these currencies were convertible, it is not clear what function the SDR serves which is not already available over-the-counter. A basket which replicates the SDR’s performance is simple to construct. Any investor could broaden that basket to include higher-rated currencies, and there is no need to await the IMF’s imprimatur. Increasing the issuance of SDR-denominated securities has also been mooted, perhaps to finance IMF lending. (The World Bank, for example, funds its lending through bond issuance, not IMF-style quotas.) But given the liquidity issues discussed on the previous slides, IMF issuance would need to be extraordinary – perhaps in excess of $100bn annually – to begin rivalling the liquidity of many second-tier G-10 or EM bond markets. Of course those bonds would have very high credit quality since they would be backed by all IMF member governments, but it is not clear that this credit advantage would outweigh the liquidity disadvantage during the first several years of market development.
Why should any country aspire to reserve currency status? It’s more than a prestige issue. The country issuing the world’s reserve currency enjoys captive demand for assets as a store of wealth, and demand for its currency as use in international trade. Several benefits should thus be obvious: (1) lower interest rates due to foreign demand for the country’s government bonds, a benefit J.P.Morgan estimates to be worth about 50bp (see A fair value model for US bonds, credit and equities, Loeys and Panigirtzoglou, January 26, 2005). Lower government bond yields also trickles down into lower mortgage rates and corporate bond yields. (2) a higher sovereign credit rating due to the financing flexibility which comes from a dedicated investor base such as foreign central banks which fix or manage their currencies against the reserve asset. (3) Less exchange rate risk for corporates, since their home currency is used to invoice international trade. The only cost is a stronger currency than what would otherwise prevail. This cost is more significant for open economies like Switzerland or China where exports are a large share of GDP (54% and 30%, respectively), than for relatively closed ones like the US where the trade share is lower (13%). Thus the dollar’s decline as a reserve currency isn’t a trivial issue. As transactional demand for dollars falls, US corporates will bear more exchange rate risk, since markets which used to routinely accept dollars for invoicing and/or settlement may demand local currency. The converse holds for European and Chinese corporates as the euro and yuan become more widely-quoted currencies. The dollar’s decline also implies higher USD interest rates all else equal, since the US will not be able to rely on official purchases of US Treasuries by central banks which maintain dollar pegs or had considered the dollar to be the most attractive reserve currency.
In additional to the shift toward a multi-polar reserve system, the other structural change in currency markets over the next decade concerns currency regimes. Currency regime refers to deliberate government policies to guide a currency’s movements. Regimes vary by flexibility, running the gamut from fixed (conventional pegs plus hard pegs such as currency unions, currency boards and dollarised or euro-ised economies) to pure floats, with numerous intermediaries (conventional pegs, crawling pegs, crawling bands, basket pegs). In practice no currency is a pure float, since almost every government has intervened in the foreign exchange market at some point since the end of the Bretton Woods era in 1971. The international monetary system is currently a hybrid of pegged, fully floating and partially floating currencies. Regime choice has obvious consequences for volatility, with pegged currencies exhibiting the least spot variation, floating ones the most and managed floats in between. Of the pegged currencies, LTL (Lithuanian) and LVL (Latvia) target EMU entry in 2014. The Gulf currencies should remained pegged to the dollar, even though this regime is increasingly inconsistent with their diversified trade patterns. It also exposes them to excessive inflation during period of USD weakness. The HKD belongs long-term in a currency union with the renminbi, but this integration could require twenty years to develop. CNY convertibility is one obstacle. The other is greater economic convergence between China and Hong Kong, since Chinese monetary policy in a renminbi currency union is probably no more appropriate than US monetary policy is under the current USD/HKD currency board. Of the floating currencies, CNY will become less managed (from the current 1% daily fluctuation limits) over time just as the CEEMEA currencies moved from crawling pegs to free floats in the 1990s. But frequent intervention will probably keep realised vol around the level of other Asian currencies (approximately 8%). CEEMEA currencies such as RON aim for EMU accession in 2015. PLN and HUF had aimed to join at some stage, but with EMU membership now entailing clear financial liabilities as the region moves towards banking and fiscal union, the cost-benefit of joining for the lower-income countries is more debatable.
The question of what drives markets seems to confound investors and hedgers more in currencies than in core asset classes. For example, near-record yen strength seems incompatible with Japan’s record debt burden (200% of GDP) or the potentially permanent damage to the country’s trade surplus from the 2011 tsunami. Likewise, the euro’s orderly decline and occasional fits of strength since the onset of Europe’s sovereign debt crisis in November 2009 seems bizarre for a currency union at some risk of disintegration. Usually such confusion reflects an inappropriate or at least incomplete framework for anticipating currency moves. Section II outlines J.P. Morgan’s thinking on a general, conceptual framework for forecasting and trading currencies. Section III then describes the models the bank uses to develop currency forecasts, and simple rule-base strategies used by overlay managers and hedgers to trade currencies systematically.
A common perception amongst academics and market participants is that currency movements are random. If they are, currencies cannot be forecast accurately nor can they be traded profitably. Investors should therefore ignore FX as a source of alpha, and hedgers should manage their exposure according to their risk preferences. Those with a mark-tomarket constraint should hedge, and those without one should leave their exposure open on a view than mean reversion will occur eventually. The best market participants can hope to manage is simply an ex post explanation of why currencies moved on a given day; there is no value in attempting to forecast or trade these markets. Thus the conventional wisdom is quite uncharitable towards currency markets. It is also wrong. Currency managers and model-driven strategies have shown an ability to generate excess returns with reasonable consistency over the past decade (chart 1), while forecasters have demonstrated decent ability to predict currency direction, even if not magnitude (see slide 22). Whether academic, investor or hedger, most market participants use one or a combination of the four approaches below, which can be categorised as monetary and non-monetary, and short versus long term. These frameworks are not mutually exclusive; they are complementary depending on the time frame over which one is trying to anticipate FX moves. The most common monetary approach is purchasing power parity, and claims that exchange rates adjust over the long run to inflation differentials. The balance of payments approach focuses on trade and capital movements, so is similar to cash flow analysis applied to currencies. The asset market approach views the exchange rate analogous to traditional asset classes such as stocks, bonds and commodities. Like securities, exchange rates have a return related to their future cash flow and should respond to new information which influences expectations about that income stream. Intervention is a more episodic influence on exchange rates now that 90% of global currencies are floating, but given the prevalence of managed floats in many countries, this issue deserves analysis of its effectiveness. The next several slides review the theory of and empirical evidence on each approach. Regardless of the framework, keep in mind the most fundamental difference between FX and other markets: currencies are driven by relative fundamentals, not absolute ones. It is the only asset class which is by definition relative value since the exchange rate is a relative price.
The oldest and simplest framework for explaining long-run currency movements is the monetary approach known as purchasing power parity. PPP contends that relative price differentials move currencies through their eventual impact on trade balances. It is potentially too parsimonious since it considers only one factor. It appeals conceptually, however, since it links prices and exchange rates, and since the FX rate is just the relative price of two assets. It also dovetails with concepts in the real economy such as trade balances through the impact on competitiveness from sustained inflation differentials. PPP has two variants – absolute and relative. Absolute PPP, or the law of one price, claims that the exchange rate should be equal to the ratio of average price levels between two countries. If good prices rise in country A relative to country B, country’s A’s currency must depreciate relative to country B’s in order to maintain the same real price for the good. This adjustment occurs through trade flows: absent trade barriers, demand would flow from country A to county B where goods are cheaper, weakening currency A versus currency B. Relative PPP focuses on inflation rates rather than price levels and claims that exchange rate movements should exactly offset inflation differentials between countries. Thus if inflation runs 10% in country A and 5% in country B, country’s A’s currency should depreciate 5% versus country B’s though the trade channel described for absolute PPP. The empirical evidence for PPP is poor: nominal exchange rates drift further and for longer than inflation differentials would predict. Regressions of monthly or annual exchange rate movements on monthly or annual inflation differentials yields have little explanatory power for most currencies. The tendency of real effective exchange rates, which adjust spot rates for inflation differentials, to trend for some currencies (chart 1) also undermines PPP. This may be because the theory is based on tradeable goods, so non-tradeables like services are excluded even though these can be much larger components of the cross-border flows in some countries. Even if all cross-border activity were goods rather than services, the theory could still fail due to taxes, transport costs and trade restrictions which prevent free exchange from rebalancing markets. PPP works reasonably well over the long run for some pairs such as USD/JPY, which has moved in line with cumulative inflation differentials over the past several decades (chart 2). The theory also seems to describe FX movements for countries with historically high inflation, such as Mexico in chart 3.
PPP’s shortcoming could be that it is single-factor and too long-term. Thus the more appropriate framework may be one which tracks multiple flows which influence currencies across the trade and investment accounts. This is the balance of payments approach, since it focuses on a country’s cross-border trade and investment activity. It is neither a cash flow statement (income and expenses) nor a balance sheet (assets, liabilities and net worth). Rather it is cash balance tracking all flows, which should net to zero. As with an individual, if expenses (imports) exceed income (exports), the individual must draw down savings (reserves) to cover the deficit, borrow from the rest of the world or sell assets to the rest of the world (both capital inflows). The balance is meaningless since it nets to zero; it’s the components which are more interesting for currency forecasting since some correlate closely and consistently with currency movements. The current account covers exports and imports of goods and services; income such as dividends and interest on overseas investments; and transfers such as government grants. The capital account reflects all financial transactions such as direct investment (physical investments, controlling interest), portfolio flows (stocks, bonds, money markets) or loans. Official reserves are transactions of the central bank in which it acquires (reserve gain) or sells (reserve loss) foreign currency. Current account, capital account and reserve transactions should net to zero, but due to unavoidable measurement gaps, any shortfall is typically referred to as net errors and omissions or the statistical discrepancy. Brazil, for example, runs a current account deficit of $53bn which is overfinanced through capital inflows of over $100bn. The difference has been absorbed through central bank purchases of USD/sales of BRL which increased reserves by almost $60bn in 2011 (table). Consider the case of the Australian dollar. Over the long term AUD tracks Australia’s trade surplus reasonably closely, such that the currency tends to rise with the trade balance (chart 2) as export earnings are repatriated. The trade/FX relationship isn’t ironclad, however. Notice 2009 when the trade surplus declined but AUD/USD appreciated . That period coincided with a widening of Australian - US rate differentials (chart 3 next slide), a development which caused an offsetting capital inflow to dominating the trade surplus. This example highlights the basic principle: certain components of a country’s balance of payments are more material for the currency trend than others. The challenge is identifying the key components, which vary by currency and over time. For AUD, NZD and BRL the consistent drivers tend to be the commodity cycle and the related impact on interest rates and foreign direct investment. For Emerging Asia FX with lower yields, the drivers tends to be the crosscurrents from the global business cycle: exports and equity inflows during global growth upturns (currency positive) versus higher oil prices (currency-negative). For the euro, stability and occasional fits of strength are not so surprising given the region’s current account surplus. Only bursts of sovereign stress manage to weaken it, though outflows from the bond and equity market.
The balance of payments approach appeals for its completeness. Its main limitation, however, is that it fails to explain why currencies exhibit considerably more volatility than do the underlying trade or even some capital flows. This deficiency has spawned the assets market approach. The asset market approach posits that exchange rates aren’t just the price of one currency in terms of another. They are also assets like stocks, bonds and commodities, so they should observe the same principles which govern securities. The three basic principles of securities valuation are that (1) the current price is the present value of all future earnings; (2) in an efficient market prices reflect all known information on current or future fundamentals; and (3) prices adjust instantaneously to any new information about those fundamentals. Because expectations influence exchange rate immediately, predictions about long-run drivers are important even in the short run. FX differs from other asset classes in two respects, however: (1) it is an outright asset as well as a medium for cross-border investment, so its value is part intrinsic and part derived from other asset markets; and (2) it is a relative price, so all fundamentals used in valuation must be considered in cross-country terms. The first issue is more problematic than the second, since forecasting an asset price based on the forecast for another asset price can compound the estimation error. To understand the influences of current and future fundamentals, consider the similarities between cash flows on a currency and cash flows on bonds and stocks. Bond income stems from coupons, stock income from dividends and currency income from cash rate differentials (or the difference between the forward rate and the actual spot rate when the forward matures). Investors’ desire for income motivates them to buy high-yield currencies just as they purchase highyield bonds or high-dividend stocks. Hence the loose correspondence between current rate differentials and currency performance, more popularly known as the carry trade (chart 1). But just as the value of stocks and bonds fluctuates as expectations around future fundamentals evolve, so do currencies. Hence the even stronger correlation between currencies and expected rate differentials (proxied by 1mo rates 12mos forward in chart 2). Section III on Modeling and forecasting exchange rates will discuss how we convert these concepts into simple and profitable trading rules. This example oversimplifies the issue, since it focuses on only one source of direct return (income) and ignores the transactional demand for currencies stemming from other capital flows and from the trade balance. Still, it highlights the joint influence of current and future fundamentals.
A final driver is intervention, which is central bank buying or selling of the domestic currency in the over-the-counter market. We consider this activity an overlay rather than a core driver of the exchange rate because intervention cannot drive a currency counter to fundamental forces over the long-run. It is a temporary influence, and one which tends to moderate a trend rather than reverse it. Central banks intervene for three reasons: to correct perceived misalignment; to moderate volatility; and to accumulate foreign exchange reserves as insurance against future balance of payments/liquidity crisis. Intervention can be sterilised, which means it has no impact on the money supply /interest rates, or unsterilised, which means it does impact those monetary variables due to offsetting operations in the bond market. Unsterilised interventions are equivalent to open-market operations conducted in the domestic market: the purchase of an asset increases the domestic money supply while the sale of assets automatically causes the money supply to decline. Only unsterlised intervention should be effective because it permanently alters the supply/demand balance between local and foreign currency. Unsterilised intervention runs the risk of being inflationary, however, which is why it is seldom practiced, or practiced for long. Intervention is extremely frequent in Emerging Asia (hence their massive foreign exchange holdings); fairly frequent in Latin America and infrequent in Emerging Europe. G-10 central banks rarely intervene. When they do, actions are typically coordinated, such as the 1985 Plaza Accord to weaken the dollar; the 1987 Louvre Accord (February 22, 1987) to then stabilise the dollar; the August 1995 G-3 interventions to strengthen the dollar; the June 1998 US/Japanese interventions to weaken USD/JPY during the Asia Crisis; the September 2000 interventions to strengthen the euro; or the March 2011 interventions to stabilise the yen following the Fukushima disaster. If conducted unilaterally, countries typically seek preauthorisation from other G-10 members, such as Japan’s unprecedented $300bn intervention in 2003-04.
Whether intervention is effective depends on the central bank’s intention. Critics often claim that intervention is pointless, that it fails to generate an immediate or sustained reversal in a currency’s direction. This statement is half-true. It is correct that intervention is not an independent policy tool. It cannot generate permanent changes in the exchange rate when central bank activity is inconsistent with broader macroeconomic policies. Thus the Plaza Accord weakened the dollar because the Fed began easing in 1985 while the Bundesbank, and the BoJ were on hold (chart 1). The Louvre Accord lifted the dollar because the Fed began tightening as the Buba eased and the BoJ lifted rates only modestly. The 2000 euro intervention was unsuccessful partly due to Fed tightening, but also due to capital flows from the US equity market bubble and cross-border M&A boom. The BoJ’s unilateral 2003-04 intervention failed because the Fed was on hold at then historically-low rates of 1%. Intervention can address unwarranted movements from temporary shocks (Japanese earthquake in March 2011). Central Bank of Brazil intervention only reversed BRL strength in 2011 and 2012 because it was accompanied by rate cuts and capital controls.
Forecasting exchange rates one of the more thankless exercises in financial markets. Academic studies contend that currencies are random walks. They follow an unpredictable path up and down, rendering it impossible to predict direction as a function of fundamental (macroeconomic) or technical (price) variables. As evidence they point to the failure of econometric models to predict currency movements out-of-sample This view is partially correct. It is true that econometric models are much more useful at explaining currency movements ex post than predicting currency moves ex ante. Yet currency forecasters have done a credible job predicting the dollar’s direction over the past decade, even if they have missed the dollar’s level by wide margins. The academic view also fails to account for the success of simple, rule-based trading models which exploit some of the concepts discussed in Section II: Fundamental drivers of exchange rates. Section III discusses long and short-term econometric models, then short-term trading models used by the J.P. Morgan Global FX Strategy team.
It is easy to establish the worth of professional forecasters, since each month their predictions are recorded in publications such as Consensus Forecasts. These predictions can then be compared against subsequent, realised exchange rates. The difference is the forecast error. Chart 1 provides an example for forecast errors on various G-10 and emerging market currencies over the past decade. The forecast error is calculated as difference between actual FX rate and the forecast over horizons of one quarter, two quarters, three quarters, one year and two years. A positive (negative) value indicates that the consensus underestimated (overestimated) foreign currency strength vs USD. If professional forecasters had perfect foresight, that error would be zero. This test isn’t the most rigorous, but it is simple and intuitive. For both G-10 and emerging market currencies the error is positive, indicating the average forecaster underestimated foreign currency strength/USD weakness, although they did correctly call the dollar’s trend lower. Forecast errors are higher over longer horisons, so range from about 1% over the quarter to 4% over the year to 10% over two years. This conservatism is understandable given most forecasters’ unwillingness to stand out from a crowd. This is a welldocumented behavioural bias which also gives rise to market trends, since investors average into positions gradually as they await confirmation, in the same way that forecasters average into a view as further information arises.
Analysts use a range of models, each appropriate for various exercises and forecast horisons. Conceptually, models vary by their inputs – fundamental or technical – and their frequency – low, intermediate, or high. Fundamental models incorporate macroeconomic variables such as terms of trade, inflation or rate expectations. Since the frequency of these variables range from daily to quarterly, so does the frequency of the models. Technical models only use past price information as inputs, but these prices can be taken from FX or related markets (rates, commodities, equities). The table categorises models by frequency and input, lists the variables typically incorporated into each and highlights the J.P. Morgan indicator or model which employs that concept. Which model is appropriate depends on what the investor or hedger is trying to achieve. Long-term hedgers and investors are typically concerned with the risks or profit opportunity from grossly misaligned currencies, so should focus on long-term valuation models such as the fundamental equilibrium framework or PPP. Conversely these frameworks are useless for a trader’s daily, weekly or monthly decisionmaking since the inputs are too low frequency and the mean reversion they attempt to exploit too slow moving. Thus these investors tend to focus on the technical frameworks described along the bottom row of the table. The chief long-term models are based on purchasing power parity and fundamental equilibrium exchange rates. Section II slide 16 discussed the PPP concept that currencies adjust over the long-run to inflation differentials between countries. A model based on this concept would compare the spot exchange rate to the cumulative inflation differential between two countries, and take the gap as an indication of over or undervaluation. One could then examine the number of months or years typically required for the exchange rate to realign with inflation differentials.
PPP appeals because it is so simple to explain, construct and implement. It is also conceptually flawed and empirically invalid, which is why J.P. Morgan uses a fundamental econometric model. PPP’s conceptual shortcoming is that is assumes only prices drive exchange rates, which as discussed in Section II, is a narrow perspective. Empirically its shortcoming is that many real exchange rates trend rather than mean revert, which implies that an apparent deviation from fair value may not be a misalignment. It may be a new fair value based on evolving equilibrium. Which economic fundamentals best explain the long-run behaviour of the real exchange rate? Typically four variables are cited: Terms of trade is the ratio of export prices to import prices and should correlate positively with the real exchange rate. For example with a commodities exporter, higher commodity prices raise the real exchange through several channels: stronger trade balance, capital flows into the resource sector and probably higher interest rates (to contain the wage inflation from the resource sector). The more open the economy, the greater this impact on the currency. Productivity, which can be proxied as GDP per capita or GDP per hour worked, is also positively related to the REER. The channel runs through wages and real interest rates, since productivity growth in the tradeables sector raises wages and the return on capital. This is the familiar Balassa-Samuelson effect from the economics literature. Net foreign assets or net investment income are two capital-account related influences. NFA is stock concept representing a country’s accumulated stock of overseas assets/liabilities from running current account surpluses/deficits over the years. NII is a flow concept covering the earnings or payments from that stock of assets or liabilities. It is typically measured as NII as a percentage of the trade balance. Both should relate positively to the REER given the cash flow implications of running persistent surpluses or deficits. The government debt level (as percentage of GDP) is typically considered currency-negative since it raises default risk, inflation risk or the country’s external financing requirement (twin deficits). Many other variables could be used, including the current account balance, external debt and inflation. Some are statistically insignificant in backtesting (external debt, inflation), or their effects are better proxied through other variables (current account).
The J.P. Morgan fair value model relates the trade-weighted exchange rate to terms of trade, productivity, government debt and net investment income. The statistical process is a panel regression run for 19 currencies (G-10 plus MXN, BRL, CLP, CZK, PLN, TRY, ZAR, KRW, CNY) over a 2000-10 sample period of quarterly data. Usually longer sample periods are preferable to shorter ones, but the 10-year window avoids the data constraints endemic to some emerging markets. All coefficients have the expected sign, are statistically significant and are interpreted as follows: a 1% increase in a country’s terms of trade relative to other trading partners raises the REER by 0.34%; a 1% increase in relative productivity raise the REER by 0.6%; a 1% increase in relative debt/GDP raises lowers the REER by 0.2%; and a 1% increase in relative net investment income raises the REER by 0.2% (table 1). Before rushing to buy cheap currencies and sell expensive ones, keep in mind two caveats. First, fair value for any asset is probably a range more than a point given the estimation errors inherent in any model. Thus misalignments from fair value are only meaningful if extreme, such as +/-10% or +/- two sigmas from the estimate. Trading or hedging based on significant deviations rather than minor ones is the approach used in Section V: Managing FX hedge ratios which discusses a contrarian trading rule based on J.P. Morgan’s fair value model. The second caveat is that valuation is not an independent market driver. Cheap assets rarely appreciate or expensive ones decline without a macroeconomic or policy trigger to force mean reversion. Currencies are slightly different in that they are asset prices with a feedback to the real economy. An overvalued currency could weaken a country’s trade balance and economy sufficiently to then weaken the currency through a trade deficit or central bank easing. A very cheap currency could swing a trade deficit into a trade surplus and then drive currency strength. But even here, the trigger for mean reversion in the currency will be some change in macroeconomic performance. Thus the mere cheapness or expensiveness of a currency is rarely sufficient reason to hedge or invest absent a macroeconomic view.
Although this framework is only useful over multi-quarter and even multi-year horisons, other valuation models can be deployed more tactically. Similar to the long-term regressions which focus on structural factors (productivity, government debt), short-term models focus on cyclical ones such as rate expectations, sovereign risk, commodity prices or equity performance which can be measured daily. These are all proxies for the capital flows described in the asset market approach discussed on slide 16. If these cyclical variables well explain movements in the currency, then extreme deviations from predicted fair value identify turning points for short-term corrections. The model’s coefficients can also be used to translate our macroeconomic forecasts on central bank policy and commodity prices into baseline forecasts for the next year. Indeed, these regressions form the baseline for the quarterly FX forecasts carried in the J.P.Morgan flagship publication FX Markets Weekly. The bank publishes daily updates on these models in the Daily FX Fair Value Regressions report posted every weekday on the Global FX Strategy website in the Daily Quantitative Research Reports section. Chart 1 provides an example of a short-term cyclical model for EUR/USD which regresses the spot rate on monetary policy expectations (Euro – US 1mo rates 12mos forward), sovereign spreads (Germany – Spain 5-yr) and equity volatility (VIX). The euro moves about 1 cent for every 10bp change in peripheral spreads, 1 cent for every 10bp change in EuroUS spreads and 4 cents for every 10-point change in equity volatility (chart 1). The coefficients can be used to translate J.P. Morgan’s forecasts on central bank policy or the sovereign crisis into a EUR/USD forecast, with the caveat that garbage in yields garbage out. The regression residual in chart 2 is mean reverting and highlights the euro’s tendency to over and undershoot cyclical fundamentals during extreme policy environments, such as the Lehman default in September 2008, the first Greek crisis in May 2010 and even the US debt ceiling drama of summer 2011. We often position against these extreme mispricings in the trade recommendations discussed in Section IV: Trading strategies for investors.
Econometrics supplies only one family of models. Others are rule-based, so called because they prescribe a simple decision rule to determine whether a currency should be bought or sold. The guideline should capture an essential driver of asset markets grounded in macroeconomics or finance. It should also be testable to verify whether the rule generates consistently positive returns once adjusted for transaction costs. These models tend to fall into two categories: momentum and value. We employ these frameworks for two reasons: they simplify decisionmaking to the core principle, and they avoid the behavioural biases which preclude rational investing. Some eschew this approach in favor of a pure discretion, as they believe the world is too complex or too unstable to be modelled. Which approach works better? There is often a false dichotomy in investing between quantitative and more qualitative, discretionary approaches. There are strong arguments on each side. Proponents of rule-driven approaches argue that models formalize one’s thought process and remove the behavioral biases against rational, systematic thinking. Advocates of a more qualitative approach contend that models are too rigid to respond to structural changes; that many market forces are too complex to model; or that markets are too efficient to allow rule-based strategies to work out of sample.
The J.P. Morgan approach has been to use the best of both: we use models to organize information, discipline our thinking, remove emotion from the process, and center the strategy discussion. We overlay judgement for those factors which cannot be quantified easily. But we apply several guidelines to rule-based approaches: Keep it simple: Occam’s razor must rule. Otherwise too much parameter drift. Focus on trading rules rather than econometrics. Econometric models assume too much knowledge, but give guidance on relationships between driving factors. Focus trading rules on direction rather than magnitude. Most investors have more confidence in the market direction than in magnitude. Combine multiple information sources (fundamentals, value, technicals) and trading styles (momentum and value) in trading models. The FX team’s models are part of a broader series of methodology notes called Investment Strategies launched in 2001 to detail the bank’s quantitative approach across asset classes, such that the series now numbers 73 papers. They are posted on the Rule-based Investing page of www.morgan.markets.com in the Investment Strategies bloc in the left-hand column. For the FX papers which are part of that IS series plus other FX quant work, see the Quantitative Research Notes section of Global FX Strategy page www.morganmarkets.com/GlobalFXStrategy. The key papers are Alternatives to standard carry and momentum in FX (2008) and Introducing Daily FX Strategy Analytics (2012).
The next few slides show several examples of rule-based investing applied to currencies. Carry and momentum are the most widely-followed trading strategies in currency markets, and probably in any asset class. Indeed, these approaches inform the majority of rule-based investment styles outlined in the Investment Strategies series launched by JPMorgan in 2001. Carry, which attempts to exploit the forward rate bias – the tendency of high-yielding currencies to depreciate less than the level implied by interest rate differentials. This anomaly can be exploited through a long-only strategy of systematically overweighting high-yielding currencies, an approach that would have generated an information ratio near 0.6 over the past decade. A conceptual shortcoming of this approach is that it presumes investors are drawn solely to currencies with high expected returns (yield), when in practice they are likely motivated by high expected risk-adjusted returns (expected return vs vol). The simplest way of testing this hypothesis is through a trading rule which goes long currencies with the highest carry-torisk ratio, computed as the one-month libor differential between currencies divided by historical 12-month volatility. This concept is analogous to the Sharpe ratio. We compute carry-to-risk ratios for each currency pair on a daily basis. The trading rule is to be long carry (buy the highyielding currency) when the carry-to-risk ratio exceeds a positive threshold level. (Note that trading at a zero threshold is equivalent to the traditional forward rate bias strategy of simply trading in the direction of interest rate differentials). The positive carry trade is closed when the carry-to-risk ratio falls below the threshold. Using the example in Table 1, a carryto-risk threshold of 0.2 (one unit of return for every five units of risk) implies buying INR/JPY, IDR/JPY, AUD/USD and NZD/USD. The bottom table compares the results on the carry-to-risk metric versus the traditional approach of selecting carry basket components on absolute yield. Two trends are clear: carry-to-risk selection tends to outperform absolute carry, and diversified baskets outperform the highest-yielding pair.
Of course, currencies do not respond only to spread levels (carry); they can also move in line with spread changes over the medium-term. That is, low-yielders do appreciate versus high-yielders when rate spreads narrow in their favor, either because rates are falling more quickly in the high-yield country or rising more quickly in the low-yield country. Movement in the forward interest rate spread is a catch-all for the range of cyclical forces which act on currencies, such as shifts in relative growth expectations or relative monetary policy. This dynamic links neatly with the asset market framework for currencies discussed on slide 18 which posits that markets respond to current and expected fundamentals. Current fundamentals are captured by the static rate differential (carry) and expectations by forward interest rate changes. It is well illustrated by the performance of AUD/USD versus current rates (carry) and rate expectations in charts 1 and 2 above. Note the 2008 period when AUD/USD collapsed even though it enjoyed a substantial rate (carry ) advantage over the dollar, since rate expectatations moved against the currency as the global economy weakened. A simple strategy is exploit this dynamic would buy the currency in whose favor rates spreads are moving. For example, a widening of the Australia – US spread would imply buying AUD/USD, while a narrowing of the spread would imply selling the pair. The only parameters in the model are the choice of interest rate, the period over which the change in spread is measured (lookback period) and the rebalancing frequency (how often the change in spreads is calculated). A range of interest rates could be used, but we focus on 1-month rates in 12 months’ time. Various intervals could be used for the lookback periods (1, 3, 6 or 12 months) and the rebalancing frequency (daily, monthly, quarterly). In general, shorter lookback periods generate stronger results, since they better identify incipient trends. Weekly rebalancing generates stronger results than a monthly model for similar reasons and also limits the transaction costs associated with a daily model. The final specification is a weekly model based on changes in the forward rate spread (1-month rates 3 months forward) over the past month. The trading rule is to position in line with spread momentum, buying the currency in whose favor the spread is moving. This strategy has yielded a return-to-risk of around 1 over the past decade. Importantly, this portfolio is much less directional with currency volatility than a typical carry basket.
In addition to dropping the dollar, carry trade performance should be enhanced by only holding carry positions where spread momentum also favors the high-yielder. Overlaying carry trades with other signals is nothing new, but the traditional approach is to do so with so-called risk appetite measures which are composite indices of volatility and credit spreads. While good at characterizing current market sentiment — bullish on carry when spreads and vol are below average, bearish on carry when spreads and vol are above average — their shortcoming is that their moves are largely coincident with carry trade performance, so have little marginal value. These indicators also reverse sharply and often during market turbulence, imposing high turnover. An alternative would be to overlay with information which is more orthogonal to the carry trade, such as signals from rate momentum. As discussed earlier, currencies respond to both spread levels (carry) and spread changes (rate momentum), so the most bullish rate backdrop for a currency would be one where it yields more than another and that advantage is increasing. A high-yield currency where rates are falling would therefore be vulnerable to reversal. A simple application of this principle is to only hold high yield currencies where rates are rising, and to close exposure in those trades where rate spreads are moving against the high-yielder. This approach essentially uses the rate momentum strategy discussed on slide 30 as an overlay to the standard carry basket. Doing so does not eliminate losses, since spread momentum and spot can reverse simultaneously, but it does result in much lower drawdown than stand-alone carry (top chart). Over the past ten years, the overlay strategy raises the IR on a standard carry basket from 0.6 to 0.8. We find that this approach also works better than arbitrary stop-loses. The bottom right chart shows the performance of a G-10 carry basket assuming that positions are unwound once intra-month losses reach a certain threshold. Trades are reinitiated the following month. For G-10, there is no material improvement from the use of stops. There is some improvement when 1% stops are applied to emerging markets baskets, but adjusted for the transaction costs of such frequent portfolio turnover, this parameter actually reduces returns.
Momentum is the empirical tendency of outperforming assets to continue outperforming in the future. In FX, the traditional approach trades in the direction of previous spot movements – buy the currency pair which has rallied – as determined by some filter or moving average rule. Despite the tendency to dismiss these frameworks as overly simplistic, the profits from such a strategy have been decent. A simple strategy of buying currencies which have appreciated over the past year have deliver risk-adjusted returns of roughly 0.5 over the long run (see Alternatives to standard carry and momentum, Normand, August 8, 2008). In principle, no trend-following strategy should generate consistent profitability if markets are efficient. However, even the strongest proponents of market efficiency acknowledge its limitations due to market segmentation (which impedes capital flows into mispriced markets) or behavioural biases (which impede instantaneous responses to new information). Momentum strategies benefit from two, well-documented behavioural biases of underreaction and overreaction. Underreaction reflects investors inability or unwillingness to adjust views and positions quickly; either because they await fuller information to make a decision, or because they are reluctant to appear non-consensus. Accordingly, prices adjust slowly towards a market’s fundamental value, in the process producing short-term trends. Overreaction is also based on cognitive biases. Although most investors adjust their expectations fully, some extrapolate this positive news into the future, thus leading prices to overshoot fundamental value. Underpinning for trend-following strategies; the issue is how best to model it. Trading models to exploit these inefficiencies typically involve two parameters: the momentum measure and the rebalancing frequency. The momentum measure can be based on simple momentum, which calculates performance over a previous lookback period, or an exponentially-weighted moving average, which places more emphasis on recent observations. The rebalancing frequency can be of any length – intraday, daily, weekly, monthly. The underlying return series can be based on spot or total returns. As noted earlier, the simple rule of buying currencies if their spot rates have risen over the past year generates an IR of close to 0.5. Overlaying price momentum with rate momentum – the principle from slide 30 - improves performance materially by raising the IR by about one-third over a decade.
Over the past 15 years, the best performing strategy in absolute terms has been emerging markets carry (7.2% per annum), followed by global carry (6%), G10 carry (3.9%), carry plus rate momentum (4.4%), rate momentum (2.8%) and spot plus rate momentum (3%). Signals from and performance of these models are reported daily in the Daily FX Alpha Chartpack posted on the Global FX Strategy page under the Daily Quantitative Research Reports bloc. Returns on rule-based strategies compare favourably to those of currency managers but are lower than those of macro hedge funds, probably because the latter have wider investment mandates across asset classes than currency overlay funds do.
Section IV outlines how currencies can be traded profitably. Of course for those who believe the academic literature, trading currencies is a pointless pursuit. The conventional wisdom claims that currencies movements are random, and that currency markets are too large and too liquid to allow any inefficiencies to persist long enough to be exploited by investors. Both claims are unfounded. If currency movements were random, currency managers would not have been able to generate positive returns over time. Neither would the model-driven strategies discussed in Section III. And the model portfolio of trade recommendations we publish each Friday in FX Markets Weekly also would perform poorly. The charts on this slide track the returns of currency managers, rule-based strategies and the FX Markets Weekly model portfolio over the past several years. Sample periods differ due to data availability. It is true that each indicator has shows poor performance and/or losses for some period or for some types of trades – for example, spot trades recently in the FXMW portfolio – but returns on average have been positive for all groups and success rates over 55% for all trades but technicals. How is this possible? We contend that contrary to the academic claim, currency markets are highly inefficient. One reason is that currency markets are arguably much more inefficient than traditional asset classes because so many market participants are not profit maximisers. Dedicated currency managers and global macro hedge funds are, but equity fund managers arguably are not. They will buy or sell a currency regardless of their view on valuation, since their primary objective is stock picking. A corporate may also transact regardless of the currency’s level since their primary objective is import/export of overseas investment. Central banks routinely buy foreign currency to maintain export competitiveness, a policy which prevents currency’s from adjusting instantaneously to new information (see next section). These actions thus can create and preserve significant deviations from fair value, excessive momentum in markets, or a very slow pace of mean reversion, all of which create profit opportunities for dedicated investors. The next several slides discuss how we turn views into trades within the FX Strategy team at J.P. Morgan.
The approach we use within the FX strategy team at J.P. Morgan is distinct from the traditional portfolio construction taught in finance texts. The traditional approach draws on Markowitz’s mean-variance framework: investors forecast returns and correlations on a range of assets, optimize for combinations of assets (or trades) providing the highest riskadjusted returns, and choose an optimal portfolio consistent with their risk preferences. Although this approach is taught widely and used frequently for long-term asset allocation, it is rarely used for tactical asset allocation or currency trading since the process is quite cumbersome. Markowitz optimization requires a view on every asset or FX pair, and recommendations are highly sensitive to inputs. Managers understandably find it difficult to have much confidence in the stated optimal portfolios when small estimation errors can sway recommendations so dramatically.
Instead, our process replicates the top-down approach in which many investors formulate views. This process follows three principles: Investors think in terms of qualitative themes driving asset markets, such as global expansion, inflation or sovereign risk Views tend to be strongly directional, but less precise on timing or targets. For example, investors likely have more conviction that a currency will rise than they have about the timing and extent of the eventual move Views tend be stated in relative terms within portfolios. Managers have relative preferences within a portfolio, even if they are unsure about the instruments to express the view. Thus a view that Euro rates will outperform Treasuries defers the decision as to which bonds should be used to execute. Similarly, managers may think the dollar should outperform in a given environment, even if they are less sure initially whether this move will be greatest versus EUR, AUD, BRL or KRW These themes are easily translated into broadly defined strategies, despite uncertainty over point forecasts and instruments. For example, a qualitative theme of global expansion implies a directional view that risky asset classes such as equity and credit will outperform safe ones such as US Treasuries and cash. In currencies, this macro theme implies selling low-yield currencies (typically USD or JPY) versus higher-yielding ones such as AUD, BRL or TRY. Specific positions are a function of the inputs described in Sections II and III — fundamentals, valuation models and technicals — the balance of which suggests a trade. Consider the macro theme of global expansion and the implications for currencies. Since global expansion typically implies rising interest rates, higher commodity prices and falling volatility, the asset market approach described in Section II would favor high-yield currencies. It would also favor the yen if that expansion would raise Japan’s trae surplus but not lift US rates. These are simple examples of the approach, but they highlight a key principle: that investors do not need to supply specific forecasts up front. A directional bias is sufficient to start, and additional complexity can be added as the view firms around the timing and magnitude of a currency move.
The complete process, outlined in the diagram on the right, is then as follows: Identify as many independent global macro themes as possible. Diversification comes from organising trades around distinct macro themes (global expansion, sovereign stress, commodity supply shocks), not from simply holding multiple positions in different regions (AUD, BRL and RUB, for example are highly correlated through commodity dependence). Identify trades which best express those themes. These trades can be fundamental or technical, and directional or relative value. They can be expressed in cash or options. Cash trades offer greater liquidity, particularly if the trade is intended to be intra-day or intra-week. Options trades have the advantage of defining the downside (when options are bought) and providing leverage. They also more flexible instruments for expressing more nuanced views around the timing and/or magnitude of the move. Size the trades by conviction, meaning greater capital is allocated to the most strongly-held view. Set stop-losses on trades to limit drawdown. Stop-losses are orders to automatically exit a position when a level is hit. Stops are almost always technical, such as a pre-defined level, percentage loss or notional drawdown. Stop losses can also be fundamental, such as change in macro data or policy environment which would warrant a change in view. As a risk management tool, fundamental stops are essential, since most people are programmed to look for white swans (signs of confirmation) rather than black ones (signs of reversal). Reassess and rebalance over a frequency consistent with the investment framework. We reassess weekly on Fridays to take stock of macro developments over the past several days. Rebalancing daily makes little sense if the primary input is macro data, since the daily news flow amounts to more noise than trend.
The next three slides provide examples of option trades we have used in the model portfolio over the past year. As noted, the model portfolio includes cash and options trades. Derivative positions carry several advantages. They allow us to (1) define the downside to a trade by owning options; (2) efficiently position around the timing and magnitude of a move. There are dozens of options-based strategies across the vanilla and exotic spectrums. The tables on the next three slide highlight the ones we employ most often in FX Markets Weekly. The list isn’t exhaustive, but it is representative of structures which are consistent with our investment approach and entail a payoff ratio which appeals to most institutional investors. They are ranked from highest to lowest leverage, which is defined as the ratio of potential upside to downside. Intuitively higher-leverage trades are more appropriate for higher versus lower conviction views. One-touches and at-expiry digitals are the most leveraged options, typically with payouts of anywhere from 5:1 to 10:1 A risk reversal is the combination of buying a call and selling a put (or selling a call and buying a put) with different strikes for the same tenor and notional amount. The strikes are generally set out-of-the-money versus the current forward. RR’s are often constructed by adjusting the strike levels so that they are zero cost Selling calls or puts is also highly directional, particularly the former since it exposes the investor to unlimited downside
The strategies on this slide are lower-leveraged strategies and/or structures to profit from limited moves in spot. Call (put) spreads purchase one options and sell another with a high strike to reduce the cost. Ratio call (put) spreads simply adjust the notional exposure on one leg of the trade to lower the cost. Adding additional barriers such as knock-outs can also cheapen the structure. Knock-ins raise the cost but can provide additional leverage A seagull is as combination of three options: long a call (or put) spread financed by te sale of an out-of-the-money put (call). This is equivalent to buying an ATM call and selling an OTM strangle (wings). The objective is to create a directional position for a move within a limited range.
If markets are expected to range trade, carry strategies are more appropriate. These can be done in cash as the rulebased strategy described on slide 29. It can also be done with options through two approaches. The simplest strategy is simply to buy ATM forward calls on high-yield currencies and sell ATM spot calls. This spread trade has the advantage of capping the downside at the option premium, unlike the cash trade executed with forwards where the downside is unlimited. The alternative options trade is a range-binary (double-no touch) which earns time decay (theta) as long as the currency remains within the specified barriers. This too is considered a carry trade since it earns premium from the passage of time if spot is stable.
Above is a case study typically use in the J.P. Morgan Training Program to test analysts’ ability to construct a diversified portfolio of currency trades. Inputs are the bank’s house view on the global economic cycle and policy outlook, plus various valuation and technical metrics. Three common oversights are (1) failure to identify more that one independent global macro themes; (2) overlooking valuation and position indicators to inform pair selection for a given theme; and (3) inability to identify the data or policy triggers which might cause a trade to lose money.
Section IV is more specialised than Sections I, II and III. It answers questions around managing FX hedge ratios, an issue which has become more critical for investors and corporates in the wake of unprecedented FX volatility during the Lehman crisis. For investors, four issues predominate: How to determine the long-term, optimal hedge ratio for global stock and bond portfolios How to time entry into a hedging program, to focus on the most expensive currencies and avoid covering exposure in undervalued ones How to deviate from the strategic hedge ratio to generate profits or manage cash flows How to choose between forwards and options in implementing a hedging program For corporates, the most frequent concerns are variants of the first, second and fourth points: how to set a baseline range for hedge ratios; which currencies are most likely to post large moves (higher where they have expenses, lower where they have earnings); and which instruments are best for executing a hedging program. Academic studies and previous J.P. Morgan research over the past two decades have discussed optimal hedge ratios in detail. More recent J.P. Morgan studies have proposed long-term valuation and short-term momentum models which can be adapted to answer the second, third and fourth questions. The J.P. Morgan research note Managing FX hedge ratios (Normand & Sandilya, May 26, 2010) updates those studies, adapts the models for dynamic hedging over various horizons, and extends the original analysis to four base currencies (USD, EUR, GBP, AUD). Slides 45-58 review and critiques the conventional wisdom on optimal hedge ratios for those unfamiliar with the framework. Slide 59 applies J.P. Morgan’s long-term fair value model to answer the investor question of how to time entry into a hedging program, and the corporate question of which currencies merit hedging focus over a 6 to 18-month horizon. Slide 60 modifies short-term FX trading models (alpha models) based on price momentum and interest rate momentum to drive tactical deviations around a 50/50 hedged benchmark over one to three-month horizons. Slides 61-63 then discuss issues specific to corporate hedging, such as balance sheet versus cash flow hedging, and proxy hedging of less-liquid currencies.
As discussed in Section I, currency exposure is endemic to international investing and corporate operations. The issues are how to manage that exposure (benchmark or policy decision to hedge or not) and how to hedge (an operational decision). Active managers continuously revisit this issue and can use models (Section III), discretion (Section IV) or a combination of the two. Passive managers take an initial decision to hedge or not hedge and retain that policy indefinitely. Full hedgers argue that currency exposure is all risk and no return, so should be removed from the portfolio. Those who do not hedge argue that FX returns wash out in the long run, so currency management is unnecessary. FX management is also expensive (due to interest rate differentials if foreign interest rates are higher than domestic ones) and administratively complex (hedged create cash flows when marked to market). Neither extreme is optimal, however. Full hedging eliminates the potential short-term gains from tactical trading (to be discussed later), while no hedging leaves the investor exposed to substantial short-term volatility. The optimal degree of benchmark hedging – the hedge ratio – typically lies somewhere in between. Determining the optimal benchmark hedge ratio is a variant of the active versus passive management issue. Just as many fund managers choose to index some portion of their portfolio (those asset classes which are most efficient) and manage those where they think they can add value (either due to market inefficiencies or superior skill), the optimal hedge ratio can also vary by investor and over time. The decision is usually taken on a case-by-case basis, given an a portfolio’s underlying liability structure, as well as each investor’s risk preferences. There is no uniform strategic hedge ratio. The next several slides discuss the though process around determining that hedge ratio.
We start by reviewing the conventional wisdom on currencies which tends to motivate passive management of FX exposure. The conventional wisdom on FX makes two claims: that FX exposure delivers more risk than return over the long-run; but that FX offers abundant short-term profit opportunities due to structural inefficiencies. If these points are correct, then investors should fully hedge FX exposure but run active overlay programs to capture short-term profit opportunities. Likewise, corporates should hedge as a matter of policy but alter target ratios over shorter horizons when they hold strong directional views. If this condition holds, then there should be no buy-and-hold benefit of open currency risk, since high (low) interest rate currencies should depreciate (appreciate) to the level of the forward rate. However, tactical trading should generate returns to investors, and tactical hedging may better manage cash flows. One way to illustrate this no long-term return concept is to consider asset market returns measured from three perspectives: local currency, unhedged into a given base currency and hedged into a base currency. The difference between local currency and unhedged returns is the foreign currency’s contribution to total returns. A zero difference would support the view that currency exposure does not augment returns, so perhaps should be hedged if volatility differentials are high. For USD-based investors, the return differential between local currency and unhedged stocks and bonds is modest over the long-term (1988 - 2011). Currency moves have augmented asset returns by roughly 1% per annum for investments in the Euro area, Canada, Australia and Japan over the past twenty years, due to those currencies’ appreciation versus the dollar (charts 1 and 2). Currency has subtracted roughly 1% from UK investments due to sterling’s depreciation since the late 1980s.
Though FX’s return impact may be modest, its volatility impact can be significant. For stocks, the difference in annualised volatility between local currency returns and unhedged returns can be massive: 7% - 8% for Australian and Canadian exposure, 3% for UK exposure and 1% for Japanese exposure. Only Euro area stocks exhibit comparable return volatility, whether measured in local currency or unhedged terms (chart 2). Volatility differentials on bonds are also substantial. Unhedged JGB returns in USD terms are 7 percentage points more volatile than local currency returns, and Euro area bonds are 6 points more volatile. The volatility of unhedged returns in UK, Canadian and Australian bond markets are roughly 4 points higher than local currency returns (chart 5). This volatility differential is much more meaningful in bonds than in stocks, since government bonds are already a relatively low-volatility asset class.
Within the G-10, it is generally accepted that passive international exposure brings uncompensated volatility over the long run. Since unhedged bond market returns are two to three times more volatile than local currency returns, a strategic – or benchmark – policy of fully hedging currency risk is sensible. In equities, the hedging decision is less clear-cut. Some investors primarily concerned with risk minimization would hedge. Others would consider a hedging program cumbersome and expensive since FX’s marginal contribution to equity volatility over the long run is small; when the underlying asset class is already highly volatile. But before delving further into equity investors’ hedging decision, consider three exceptions to the conventional wisdom that passive FX exposure represents uncompensated risks. These exceptions concern (1) emerging markets exposure; and (2) FX as catastrophe insurance and (3) FX as a portfolio diversifier. Unlike G-10 currencies which tend to mean-revert, emerging market currencies can offer trend positive returns. This excess return stems from two sources — real appreciation and carry. Emerging markets currencies often experience long-run real appreciation due to a faster rate of productivity growth (the convergence process). At the same time, interest rates also tend to be above those in G-10 markets, reflecting a higher marginal productivity of capital, a risk premium for convertibility and exchange control, and a policy tool to promote disinflation. This combination of real exchange rate appreciation and interest rate differentials can persist for years (chart 1), and thus generates a meaningful return differential over time to justify their higher risk. We track these excess returns through JPMorgan’s Emerging Local Markets Index (ELMI), which measures the return in dollars of cash instruments (Libor, t-bills, FX forwards) in 24 emerging markets. Chart 2 shows the Sharpe ratio on the index and its regional sub-components since 1994. EM FX has outperformed 6-mo dollar cash by 4% annually since the early 1990s. Outperformance has been much higher for convergence countries: Central European currencies have outperformed USD libor by over 7.5% annually, while Latin currencies have outperformed by 1.5%. Risk-adjusted returns on the index are decent (0.42), which is comparable to that on US equities and high-grade credit.
Strategic FX exposure is also useful as a hedge against local event risks, such as political uncertainty and natural disasters. For example, many insurance companies often have significant, unhedged USD holdings. In the event of a natural disaster, the hit to their balance sheets would be partially offset by gains on the local currency value of foreign holdings, assuming the dollar appreciated in response to those developments. Similarly, many investors in emerging markets hold their foreign exposure (in the US, Europe or Japan) unhedged. In the event of political uncertainty or financial crises, local currency would likely weaken versus the G-3, providing some offset to the losses on domestic assets. Finally, investors who have significant foreign currency liabilities — such as global pension funds, multinational corporations or central banks — likewise match that exposure with unhedged foreign currency assets.
The third exception for holding unhedged benchmark exposure is risk diversification: currency and asset risk may be sufficiently negatively correlated so as to lower overall portfolio risk. Remember that the variance of a portfolio is the sum of individual variances plus a measure of their comovement. In the case of a portfolio combining a domestic and foreign asset, the portfolio’s variance will be a function of the (1) domestic asset’s variance; (2) foreign asset’s variance; (3) currency’s variance; (4) covariance between the domestic and foreign assets; and (5) covariance between the assets and the currency. We can illustrate these components algebraically as σportfolio = w2domestic σ2domestic + w2foreign σ2foreign + 2 wdomestic wforeign σdomestic, foreign + H2 σ2fx + 2H( wdomestic σdomestic, fx + wforeign σforeign, fx) [Equation 5.1]
where H is the proportion of the portfolio with foreign currency exposure. The last two terms capture the impact of currency exposure on total portfolio risk. For the fully hedged portfolio, the variance of the currency exposure will be zero (H = 0). The last two terms of Equation 5.3 drop out and the expression reduces to σ fully hedged = w2domestic σ2domestic + w2foreign σ2foreign + 2 wdomestic wforeign σdomestic, foreign [Equation 5.2]
Hedging out the currency risk leaves the variance of the portfolio as a function of the individual asset variances and the covariances between the asset returns, the same as if this were a domestic two-asset portfolio.
Under what conditions would unhedged exposure reduce overall portfolio volatility? Equation 5.1 represents the variance of the unhedged (or partially hedged) portfolio, and Equation 5.2 that of the fully hedged portfolio.We can rearrange terms (subtracting equation 5.2 from 5.1) to illustrate that currency exposure will reduce total portfolio risk if the following condition holds: w2foreign σ2fx + 2 wforeign ( wdomesticσdomestic, fx + wforeign σforeign, fx ) < 0 [Equation 5.3] In general, the covariance of currency returns with asset returns must be sufficiently negative to overcome the volatility of the currency itself. More specifically, A positive correlation between the assets and the currency increases total portfolio risk; If sufficiently large, a negative correlation between assets and the currency can offset currency volatility; If there is zero correlation between the currency and the foreign asset, the currency’s correlation with the domestic asset must be more negative in order to reduce total portfolio volatility; If currency returns are less volatile than asset returns, the negative correlation can be somewhat closer to zero and still reduce portfolio vol.
How negative must the correlation be for currency exposure to lower portfolio variance? Consider an example in which the volatility of the domestic and foreign assets are equal, and the domestic and foreign asset correlations with the currency are equal. In this case, Equation 3.3 reduces to ρ foreign, fx < -wforeign σfx / 2σforeign [Equation 5.4]
We can plug in different volatilities for the assets and currency and different allocations to foreign assets, and solve for breakeven correlations which reduce total portfolio risk. For example, if the currency and asset returns are equally volatile (vol ratio = 1) and 10% of the portfolio is allocated to foreign assets, then the correlation between currency and asset returns would need to be weaker than (more negative) 0.05 in order to lower overall portfolio risk. If 50% of exposure were foreign, then the correlation would need to be greater than -0.25. If the currency were more volatile than the asset market (vol ratio = 1.2), then the breakeven correlations would need to be even more negative for a given foreign allocation in order to reduce portfolio vol.
In practice asset/FX correlations are neither sufficiently nor consistently negative to reduce portfolio volatility by leaving currency exposure unhedged. For USD-based investors over the past two decades, only European stocks have tended to correlate negatively with their currency performance versus the dollar (top chart), implying that their currencies depreciate versus the dollar when equities rise . But that apparent diversification benefit disappears over a ten-year sample period (correlations close to zero) and over a five-year sample (the long-term correlation has flipped to positive). Correlations between Australian/Canadian equities and their currencies versus the dollar have almost always been positive (bottom chart), which thus makes unhedged equities more volatile for US investors. The correlation between the Nikkei and the yen’s performance versus the dollar has been negative, but the strength of this relationship varies over time.
In the final balance, what hedge ratio makes sense strategically? There is no uniform, strategic hedge ratio. The appropriate policy is particular to the investor given four variables: (1) the allocation between domestic and international assets; (2) the currency allocation of foreign assets; (3) the consistency of historical volatilities and correlations in the future; and (4) the investor’s risk preference. The optimal hedge ratio therefore will vary by investor and over time. While there are no absolutes, several guidelines apply to the merits of fully hedged, unhedged and semi-hedged benchmarks. For investors in G-10 bonds, FX exposure should be mostly hedged given how currency volatility often drives overall portfolio risk. The exceptions are for catastrophe insurance and asset/liability matching discussed on page 7. FX hedge ratios for equity portfolios are more debatable. For investors concerned mainly with minimising volatility over the long term, 100% hedged benchmarks are lower variance than unhedged ones for USD, EUR and GBP-based investors given the generally positive correlation between foreign currency performance and foreign equity markets. The opposite holds for AUD-based investors: unhedged portfolios are less volatile over the long term. For those investors seeking to minimise volatility, 100% hedged benchmarks entail important limitations. Full hedging eliminates potential short-term gains from tactical trading. Given the profitability of active currency managers and rule-based trading strategies, 100% hedging precludes a potential alpha opportunity. Section III discusses this issue in more detail. Even a 100% hedge ratio with the flexibility to deviate from the policy is quite constrained. If the benchmark is 100% hedged against the base currency, the manager may hedge less than the benchmark but not more. Thus the manager can only outperform the benchmark in environments when the foreign currency is rising.
Full hedging can also impose substantial cash flow requirements during period of extreme market stress, such as the 2008-09 credit crisis. Ironically in 2008, some investors found their fully-hedged benchmarks to be even more volatile than unhedged ones because they were short a foreign currency which was appreciating as the foreign equity market fell. In some cases investors were forced to liquidate underlying assets to fund the cash flow obligations of a currency hedging program, thus reinforcing the decline in equity and currency markets. Semi-hedged benchmarks (50/50) faced a similar dilemma, although to a lesser degree Such would have been the predicament of UK and Australian investors who hedged the currency risk on S&P500 exposure (so were short USD vs GBP and AUD as both currencies collapsed), or US hedgers who were short the yen as an overlay to their Nikkei investments. Charts 1 and 2 highlight how, for the first time in decades, unhedged equity returns were more volatile than hedged ones. In those case where a zero hedge ratio seems sensible long-term due to a negative correlation between foreign currency and equity returns – the case in foreign equities from an AUD perspective – such a policy could expose investors to substantial short-term volatility. And an unhedged benchmark limits flexibility as much as a 100% one does. If the benchmark is unhedged against the base currency, the manager may hedge more than the benchmark but never less. Thus the manager can only outperform the benchmark in an environment when the foreign currency is depreciating.
Given the particulars of investor or corporate exposure and the tradeoffs inherent in various policy options, risk managers have two options for selecting the optimal hedge ratio. They can run a mean-variance optimization to determine the minimum variance hedge ratio, then overlay some discretion in the final policy decision. Alternatively they can adopt a symmetric benchmark hedge ratio of 50%. Symmetric benchmarks appeal because they address the risk inherent in overseas investing; allow flexibility to manage cash flow; and minimize the risk of overfitting inherent in mean-variance optimization. They also allow investors to capture profit opportunities. With symmetry, if managers believe the base currency will appreciate, they can hedge the foreign currency. If they expect the base to depreciate, they can buy additional foreign currency exposure over the benchmark. The payoff structure resembles a zero cost call option on the currency which allows the investor to participate in currency gains while avoiding currency losses (chart). It is thus the policy of least regret for many investors. Even if the 50/50 policy appeals intuitively as a benchmark, many situations require a more dynamic approach, particularly for those investors concerned about entry levels, cash flows and profit opportunities. Slides 59 and 60 touch on these issues by applying fair value and momentum models to adjust hedge ratios around a bechmark.
100% hedging can create onerous cash flow obligations, 0% hedging leaves investors and corporates too exposed to exchange rate swings, and a 50% hedge ratio strikes some as arbitrary. An alternative strategy would focus hedging on the most misaligned currencies: hedge expensive pairs, not cheap ones. J.P. Morgan’s fair long-term fair value model can inform this process. The model derives fair value estimates for G-10 currency cross rates from the long-term relationship between real trade-weighted exchange rates and fundamental economic drivers. FX misalignments are statistically and economically significant in predicting currency moves out of sample over 6-, 12and 18-month horizons. A back test over the 2004-08 period shows that trading rules exploiting misalignments consistently outperform carry. By implication, adjusting medium-term hedge ratios in response to misalignments should improve portfolio performance or reduce hedging costs.
Dynamic hedging around a medium-term benchmark requires discretion or trading rules. The latter is tested in this section, building on two momentum models commonly used by currency overlay managers and global macro funds. Price momentum is the most basic trading strategy; it simply buys (sells) the best (worst) performing pairs. A rate momentum strategy, or forward carry, would buy currencies in whose favor interest rate expectations are moving. Standard industry models generate signals for two to four week horizons. Minor modifications, however, can generate signals of one to three months, which are more appropriate for hedge rebalancing. A price momentum model which adjusts dynamically around a 50/50 hedge ratio outperforms the benchmark by about 100bp annually, depending on the base currency. Information ratios on the strategy range from 0.2 to 0.5. A rate momentum (forward carry) model generates comparable outperformance but with more consistency across sample periods. Strategies are robust to various sample periods and model specifications.
Most of the previous section applied to investors. Corporate face additional challenges. The most frequent questions centre on five points: 1. Coverage: should the balance sheet or only cash flows be hedged? Most corporates would not hedge balance sheet exposure if they plan to be invested in the country for a very long time. The cost could also be substantial given the size of foreign exposure. Private equity firms are most likely to hedge the investment since they intend to dispose within a few years. Corporates tend to hedge cash flows only, on a rolling basis. 2. Hedge ratios: should all known cash flows are only a portion of them be hedged? Optimal hedge ratios are not uniform across corporates. Depends on predictability of cash flows, tightness of margins, natural currency diversification of the firm’s business and treasury’s ability to forecast exchange rates. In J.P.Morgan’s quarterly Corporate Hedging Survey, corporates on average hedge 75% of quarter-ahead cash flows and 25% of year-ahead. 3. Management: should hedge be centralised with the parent company or delegated to local subsidiaries? Centralised hedging takes portfolio approach to the firm’s exposure, so benefits from netting. In many EM currencies (Asia), however, exchange controls could require the local subsidiary to hedge onshore. Most corporates centralise hedging unless exchange controls are prohibitive.
4. Instruments: should hedging be done with forwards or options? Forwards are considered simpler, less-risky instruments because they guarantee a conversion rate for future cash flows. Still, many corporates are reluctant to hedge when foreign rates are above domestic ones, thus entailing a negative carry hedge. The conventional wisdom on forwards understates their limitations. Options such as vanilla currency puts have the advantage of entailing a defined downside (premium paid) and can be structured as zero-cost instruments (risk reversals/collars). 5. Timing: should hedging be done on a fixed schedule or opportunistically? Fixed hedging every month, quarter or year should be done when the objective is to minimise cash flow volatility and the corporate has no view on currency direction. Opportunistic hedging is more cost-effective when the corporate has some success in identifying the currencies most vulnerable to a large move. The treasurer could control for forecast error by hedging less than 100%.
6. Proxy hedging: should more-liquid currencies be used to hedge less-liquid ones? The merit of proxy hedging depend on four variables: (1) beta between underlying exposure (asset/earnings stream) and proxy variable; (2) liquidity of underlying versus proxy; (3) cost of underlying versus proxy; and (4) size of underlying exposure relative to total portfolio/corporate exposure. Proxy hedging is sensible where the exposure is meaningful, the beta high, the liquidity deeper elsewhere and the cost cheaper.
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