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Currency benchmarks for

by Jason Batt and Bilal Hafeez, Deutsche Bank

End users have embraced the Deutsche Bank Currency Indices
because they provide a cheap and efficient means of gaining
exposure to the returns inherent in the FX market, they are very
liquid and transparent, they allow non-specialist FX market
participants to benefit from Deutsche Bank’s (DB) intellectual
capital and leading market position, and exposure to them is
offered in a number of simple and easy-to-trade formats.

Whether it is competitive pressures from other fund managers, The real paradigm shift has been to recognise these
or stakeholder pressure to meet increasing pension fund returns as ‘beta’ rather than ‘alpha’ alone; in other words,
liabilities, investors are continually being pushed to generate to acknowledge that there is an inherent return available
higher returns with less volatility. One of the best ways to in currency markets. Importantly, we can show that

achieve this is to include more assets that simultaneously
offer higher returns and increased diversification. It therefore
comes as no surprise that investments other than bonds and
equities have proven to be an area of great focus in recent
years. The biggest pitfall of many investments outside of
bonds and equities, however, is their relative lack of liquidity,
which makes larger allocations prohibitive. In this context,
foreign exchange stands out. It has the highest daily turnover
Jason Batt Bilal Hafeez
of any market, a track record of positive excess returns and it
offers true diversification to bonds and equities.
Jason Batt, Global Head of Currency Index Products
In a March 2007 DB Research piece: “Currency Markets: Is tel: +44 (20) 7547 1661
money left on the table?” we showed that currency markets e-mail:
have inherent positive returns over time. The existence of
a sizeable proportion of market participants who do not Bilal Hafeez, Managing Director and
maximise profits, the fact that market participants have Global Head of FX Strategy
different objectives and beliefs, and the historically positive tel: +44 (20) 7545 0354
returns of following three investment approaches: carry, e-mail:
momentum and valuation all provide evidence for this.

The Euromoney Foreign Exchange & Treasury Management Handbook 2008

given that the daily turnover now • Undervalued – similar to incorporating a ‘fundamental’ exceeds US$2 trillion and the market has been trading metric such as earnings or revenue as often used in for more than 20 years since the end of Bretton Woods in equity indices. these rules • Select from the currencies of the Developed World – to Carry meet liquidity requirements. such that the characteristics of these rules are consistent with those of other Brief summary of the rationale for established benchmarks. of the existence of a risk premia. The DBCR carry index goes long the three Currencies appear to trend over time.benchmarks in other asset classes that are viewed as • Positive momentum – similar to market cap weighting representing the market return. The Euromoney Foreign Exchange & Treasury Management Handbook 2008 . the three with the lowest spot-exchange rate relative they really reflect a set of transparent rules that capture to the fair value level of PPP. participants and the differing constraints and objectives faced by market participants. though we a substantial portion of the returns of a given market. the use of different New Zealand dollar (NZ$) and Canadian dollar (C$). Japanese buying high interest rate currencies and selling low yen (¥). which suggests currencies with the highest yields and short the three that using past prices may be informative to investing in currencies with the lowest yields. Australian dollar (A$). are in fact trading and minimum capitalisation rules. Norwegian interest rate currencies may be profitable. positions in currencies. currencies. which suggests that systematically G10 economies: the US dollar (US$). we get around the issue being widely followed. British pound (£). Swedish krona (SKr). they become benchmarks. This is due to the existence of irrational traders. Exploits the widely observed ‘forward premium puzzle’ The DBCR Index is constructed from the currencies of the or ‘forward rate bias’. The DBCR Momentum Index goes long the three currencies with the highest return against the US$ benchmark club? and short the three currencies with the lowest return The absence of a benchmark for the currency market is against the US$. or beta. rules that capture the bulk of returns of the given market. the accepted and go short the three with the highest spot-exchange benchmarks of other asset classes indicate a level of rate relative to the fair value level of PPP. By may arrive at lower returns. quite conspicuous. of picking arbitrary over. In this way. Swiss franc (SFr). which could lead to a risk of ex-post Currency beta: the Deutsche Bank optimisation Currency Returns (DBCR) Index • Finally. The 10 currencies in the DBCR Index universe are ranked each quarter according to their three-month Momentum LIBOR yield. euro (€). we create our benchmark DBCR Index by simply DB has identified four broad rules by which to take taking the average of the three strategies (rules). models to forecast currencies by rational market • Positive net yield (or carry) – similar to bond indices. This is because krone (NKr). and go long subjectivity that would not otherwise be apparent. 1973 and the more widespread adoption of capital account For valuation we rank the 10 currencies according to convertibility through the late 1970s and early 1980s. In fact.and undervaluation extremes such as +/-20%. their purchasing power parity (PPP) exchange rates When viewed as a set of trading rules. The 10 currencies in the DBCR Index universe are ranked each month by their annual return against the Currencies: last one to join the US$.

which trades on an OTC basis rather than on an exchange where closing levels could The paradox of optimisation and carry reliably be used. availability and over-investment in certain markets or strategies. such as the DB Currency Index. the issues In the long run. Such portfolios have It needs to be reliable delivered strong returns over the decades. Yet the due to trading. even in the The Euromoney Foreign Exchange & Treasury Management Handbook 2008 . information and other costs. such as the Japanese yen. are suffering ‘one-in-100. We can then ‘optimise’ the robust over time across multiple data sets. This order of construction ensures that results will be currency pairs in the portfolio. Modern finance theory was one cause of last summer’s turmoil Valuation Although August 2007 may seem a long time ago. We start mean-variance optimisation (MVO). of sample bias that many ’optimised’ indices have because they were constructed from data mining rather than logical This is all well and good. these are particularly trade in particular.000 year losses’. It is common to construct a portfolio of carry trades to diversify the risk. We can of reliable market data. However.the possibility that prices provide information about A note on optimisation in indices non-fundamental currency determinants or that prices may adjust slowly to new information. All we need are calculation. our the possibility of profiting from currencies as they revert commonly used notions of risk must be wrong if hedge funds back to their fair values over the long-run. should be particularly aware that an over-complicated set investors are just as likely to experience losses as gains. because markets are not efficient. and the stock market crash of 1987). This technique adjusts with trading logic which is corroborated by research and the weights of each currency pair in the portfolio to deliver economic rationale. DB indices are built in one of the central tools of modern finance theory is used. A set of trading rules are built from this the highest returns for a given level of volatility. volatilities and correlations of the set. but it needs becomes the riskiest market. This allows for biggest lesson has not been fully appreciated. If they were. There are also some more esoteric factors An FX carry trade takes place when an investor borrows that are a critical part of the intellectual property that the in a low-interest rate currency. currencies tend to move back to their fair of how central banks should respond to such events. The process which forms the rules governing the index construction and by which this is done is surprisingly simple. comparable to Another very important factor is ensuring the robustness those in equity markets. the frequency of rebalancing and see this clearly in currency markets in general. the market from which the ‘risk-free’ rate is taken (money markets) suddenly Easy to pick the rules. The culprit is a dogmatic belief in modern finance DB’s investable indices are designed with regard to some theory that results in the under-appreciation of true ‘risk’ quite obvious considerations such as liquidity. relevant for the FX market. non-specialist investor is leveraging when they invest in a and invests in a high-interest rate currency. This last point is often overlooked but investors MVO is built on the idea that markets are efficient. the value based on (PPP). and ‘once-in-a-lifetime’ events to be investable recur (remember LTCM in 1998. and the carry the sources of fixing references. That is. but critical in this context that it is unrealistic to assume historic performance will be because FX carry trades seem to be profitable precisely repeated after the index launch date. of index performance over time. These rules are then tested over a lengthy data the expected returns. that is. a logical order which ensures their robustness. It of index rules can have parameters optimised in such a way may seem like a technical point. New Zealand dollar. however we must realise that trading rules. avoiding the out portfolio for the ideal degree of diversification. To further enhance these returns. in the short. complexity of financial products and the disintermediation currencies can deviate considerably from their PPP values of banks from the credit process have been medium-run.

During periods of carry losses.000 years. Focusing on NZ$/¥ volatilities. when in fact we should care more are reporting earnings more frequently and importantly it about ‘extreme downside risk’. the DBCR has delivered excess returns of close For over two years DB has been marketing variations on to 4% with a Sharpe ratio of 0. Correlation lend themselves to becoming benchmarks for their is no different. It appears that returns broadly follow a cycle so. rather than U$3000. correlations respective strategies. but in some cases are higher for carry (Exhibit The flaws are more apparent if we look at the assumptions 1). It appears that valuation and carry returns would be dramatically higher. while momentum has a negative 1980 would have grown to US$6000. US$100 invested in have positive correlations. But you cannot have it both ways. DB currently makes markets in between currency pairs pick up and so the diversification one all three DBCR sub-indices in various formats including thought one had fails to hold when most needed. Yet. and then reducing ones’ exposure after them. this has the unfortunate implication of giving signals to also appropriate for FX markets. in a ‘normal’ world. Between 2002 and 2007.6% with a Sharpe ratio of trades would not be profitable.presence of acceptable levels of risk premia. lower than any of the individual strategies and the Sharpe and volatilities and correlations are stable. a one-day loss of more than 3% would only be seen once every The low correlations between the individual strategies 4. increase one’s exposure to carry trades just before sharp losses. Using income markets. we find that one-year (historic) volatility has ranged from 5% to 29% with even wider swings for one-month volatility. What about alternative benchmarks? Worryingly. if we exclude the correlations are low and often negative between the the 25 largest one-day losses since 1980. allowing for increased leverage The second assumption is as shaky. if all correlation with both. markets being efficient. dynamic carry indices.80 and a maximum peak-to. Dynamic indices perform much trough drawdown of 11%. Of particular interest to the investor community has been How does the Deutsche Bank Currency DB’s harvest family of indices.000. on markets not being efficient. the DBCR draw-downs are unambiguously behind MVO. contracts for difference and options. returns are included. extreme trading days! The fundamental flaw in MVO is that it This reduces mark-to-market volatility for investors who optimises to ‘average risk’. periods of low volatility tend to get interrupted by Just as multiple benchmarks exist in equity and fixed sharp spikes in volatility triggered by carry trade losses. correlations are unstable in the real world. Since 1980. as in investors are employing an investment strategy premised equities. This is due to the fact that were normally distributed then extreme gains or losses would strategies tend to perform well at different times. then FX carry an annualised excess return of 4. namely. that returns are normally distributed. while at the same time with bull markets tending to last much longer than bear employing an optimisation technique that is premised on markets (see Exhibit 1). both volatilities and when investing via options. From another angle.78. However. currencies appear to have bull-and-bear markets. Although there The Euromoney Foreign Exchange & Treasury Management Handbook 2008 . If FX carry returns ratio is higher over the long-run. and so not have much impact on overall returns. we’ve already seen four such manifest themselves in a lowered overall DBCR volatility. Returns (DBCR) Index perform? DB Currency Harvest Since 1980. reduces the volatility and hence the cost of hard options bought on the DBCR Index. In comparison to the DBCR. which The three sub-indices of the DBCR broad market benchmark prevents capturing the typical recovery in profits. it had better over time than static carry indices. The paradox then is that 0. DB believes that multiple benchmarks are MVO. the investment return statistics for the component strategies are lower for momentum and The nuisance of extreme returns valuation. we find that FX carry strategies (Exhibit 1).

3% 0.3% Sharpe ratio 0.0% 3.46 0. save DEM.98 Momentum 3.9% 5.35 0.0 0.0 2-year rolling Sharpe ratio 15 1. would have kept returns close-to-unchanged for DBCR Source: DB Global Markets Research The Euromoney Foreign Exchange & Treasury Management Handbook 2008 .5 20 Excess returns (over risk-free rate).9% 4. and excludes legacy euro currencies.54 * Includes transaction costs and carry. DBCR returns Exhibit 1 Excess returns of DBCR Rolling 2-year risk-adjusted returns for DBCR 25 3.59 0.46 Valuation 4.1% 3.8% 4.2% 5.32 0.5 5 0.0 -5 80 82 84 86 88 90 92 94 96 98 00 02 04 06 82 84 86 88 90 92 94 96 98 00 02 04 06 Summary statistics of DBCR and components 1980-2006 1990-2006 2000-2006 DBCR Excess returns* 4.9% Volatility 5.1% 5.41 0.1% 7.5 10 1.77 0.76 0.65 0.0% 2.0 0 -0.5% 0.5 -1.0% 0. Including them. includes transactions costs % 2.0 2.8% 3.94 Maximum drawdown -11% Carry 4.

67 selecting the one highest-yielding currency to be long of and the one lowest yielding currency to be short of. there are two dynamic carry indices which draw on currencies for an expanded Source: DB Global Markets Research universe of twenty currencies. yielding currencies to be short. The G10 Currency Harvest Index selects the three with a balance of G10 and non-G10 exposures.35 three to five currencies to be long and short of still captures the bulk of the carry differential in the currencies’ yields. For this window mechanism which helps ensure returns from these reason. with the selections DB has created the Deutsche Bank Currency Returns (DBCR) coming from the entire universe of 20 currencies. the DB Balanced Currency Harvest Index and the DB Global Currency Harvest Index. and the Turkish lira (TL). Polish zloty (Zl). which forms the carry component of the DBCR benchmark Index. Global Currency Harvest also selects the five highest yielding In addition to the 10 G10 currencies. Currency Harvest 6.84% 0. 10 other currencies may currencies to be long of and the five lowest yielding currencies be included in the Balanced and Global Harvest Indices. Singaporean dollar of twenty currencies. They each select which currencies to go long exchange rate. to be short of. while others Annualised Sharpe have been selected as a long or short at various times and Index excess return ratio been omitted from the component currencies at others. DB Balanced A diversified carry basket is much more efficient than merely Currency Harvest 15. with selections coming from the entire universe drawn from the Korean won (W-offshore). have spent time as both a long and short currency in the highest yielding carry basket. utilising the innovative roll many non-G10 currencies move in the same way. Czech koruna (Kc). Brazilian real (R$ – offshore). the most popular of the dynamic carry indices because it The major difference between these indices is the rule on forces a generally more diversified selection of currencies. the non-G10 currencies have the extremes of rand (R). and in the event that there are shocks to and short of based on three-month LIBORs and they each one non-G10 currency. The Euromoney Foreign Exchange & Treasury Management Handbook 2008 . The Balanced Currency Harvest Index In summary selects the five highest yielding currencies to be long and the five lowest yielding currencies to be short. The other more narrow benchmarks for specific strategies. composition.are some core components to the carry trade such as being A summary of the three indices’ returns short ¥ against long NZ$. but with the Index to act as a practical broad benchmark for returns caveat that at least two of the high yielding currencies and inherent in the currency market. South African Typically.03% 1. in addition to creating two of the low yielding currencies must be G10 currencies. The main risk in these types of strategy is the same way. Hungarian forint interest rates and hence would be selected as the long (Ft). but there are no restrictions on which (S$-offshore). but DB G10 has a much lower volatility than a single currency pair. contagion can become an issue as rebalance on a quarterly basis. with the selections limited to the G10 currencies.87 In addition to the G10 Harvest Index. many currencies. the DB Balanced Currency Harvest Index has been indices stay with those who are invested in them. peso (Mex$). Mexican currencies may be selected as high or low yielders. or short components of each index on each rebalancing The three Harvest Indices are constructed in broadly the date. such as the Exhibit 2 and Sharpe ratios for the period 2002 to 2007 US$. Taiwanese dollar (NT$ – offshore). It has also highest yielding currencies to be long and the three lowest historically exhibited the best Sharpe ratio. A basket of DB Global Currency Harvest 12.15% 1. NKr and SKr.

70 Sharpe ratio 0.60 0. Lehman’s Global Aggregate Index for bonds. Asset classes Exhibit 3 Excess returns across asset classes 6 5 4 % 3 1980-2006 1990-2006 2 1 0 Currencies Bonds Equities Risk-adjusted returns across asset classes 0.90 0.20 0. 3% -2% 38% -6% 100% FX value -25% 7% 66% 40% -25% 100% Source: DB Global Markets Research.50 0.80 0.40 1980-2006 1990-2006 0. and MSCI World for equities The Euromoney Foreign Exchange & Treasury Management Handbook 2008 .30 0.10 0 Currencies Bonds Equities Correlation between asset classes Bond Equity DBCR FX FX FX carry Mom. value Bond 100% Equity 26% 100% DBCR -21% 5% 100% FX carry -16% 4% 74% 100% FX mom.

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