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Currency Strategy @Team-FLY Wiley Finance Series Currency Strategy: The Practitioner’s Guide to Currency Investing, Hedging and Forecasting Callum Henderson Investors Guide to Market Fundamentals John Calverley Hedge Funds: Myths and Limits Francois-Serge Lhabitant The Manager’s Concise Guide to Risk Jihad S. Nader Securities Operations: A Guide to Trade and Position Management Michael Simmons Modelling, Measuring and Hedging Operational Risk Marcelo Cruz Monte Carlo Methods in Finance Peter J¨ckel Building and Using Dynamic Interest Rate Models Ken Kortanek and Vladimir Medvedev Structured Equity Derivatives: The Deﬁnitive Guide to Exotic Options and Structured Notes Harry Kat Advanced Modelling in Finance Using Excel and VBA Mary Jackson and Mike Staunton Operational Risk: Measurement and Modelling Jack King Advanced Credit Risk Analysis: Financial Approaches and Mathematical Models to Assess, Price and Manage Credit Risk Didier Cossin and Hugues Pirotte Dictionary of Financial Engineering John F. Marshall Pricing Financial Derivatives: The Finite Difference Method Domingo A. Tavella and Curt Randall Interest Rate Modelling Jessica James and Nick Webber Handbook of Hybrid Instruments: Convertible Bonds, Preferred Shares, Lyons, ELKS, DECS and Other Mandatory Convertible Notes Izzy Nelken (ed.) Options on Foreign Exchange, Revised Edition David F. DeRosa Volatility and Correlation in the Pricing of Equity, FX and Interest-Rate Options Riccardo Rebonato Risk Management and Analysis vol. 1: Measuring and Modelling Financial Risk Carol Alexander (ed.) Risk Management and Analysis vol. 2: New Markets and Products Carol Alexander (ed.) Implementing Value at Risk Philip Best Implementing Derivatives Models Les Clewlow and Chris Strickland Interest-Rate Option Models: Understanding, Analysing and Using Models for Exotic Interest-Rate Options (second edition) Riccardo Rebonato Currency Strategy The Practitioner’s Guide to Currency Investing, Hedging and Forecasting Callum Henderson JOHN WILEY & SONS, LTD Published 2002 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): firstname.lastname@example.org Visit our Home Page on www.wileyeurope.com or www.wiley.com Copyright ▯C 2002 Callum Henderson All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or emailed to email@example.com, or faxed to (+44) 1243 770571. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the Publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Other Wiley Editorial Ofﬁces John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Library of Congress Cataloging-in-Publication Data British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0-470-84684-4 Typeset in 10/12pt Times by TechBooks, New Delhi, India Printed and bound in Great Britain by Antony Rowe, Chippenham, Wiltshire This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production. Dedicated to Tamara, Judy and Gus @Team-FLY Contents Acknowledgements xiii Biography xv Introduction 1 Part One Theory and Practice 15 1 Fundamental Analysis: The Strengths and Weaknesses of Traditional Exchange Rate Models 17 1.1 Purchasing Power Parity 17 1.1.1 Reasons for “Misalignments” 19 1.1.2 Tradable and Non-Tradable Goods 20 1.1.3 PPP and Corporate Pricing Strategy 20 Example1 20 Example2 22 1.1.4 PPP and the Real Exchange Rate 24 1.2 The Monetary Approach 25 1.2.1 Mundell–Fleming 27 1.2.2 Theory vs. Practice 29 1.2.3 A Multi-Polar rather than a Bi-Polar Investment World 30 1.2.4 Two Legs but not Three 30 1.2.5 Implications for EU Accession Candidates 31 1.3 The Interest Rate Approach 31 1.3.1 Real Interest Rate Differentials and Exchange Rates 33 1.4 The Balance of Payments Approach 34 1.4.1 A Fixed Exchange Rate Regime 35 1.4.2 A Floating Exchange Rate Regime 36 1.4.3 The External Balance and the Real Exchange Rate 37 1.4.4 REER and FEER 38 1.4.5 Terms of Trade 39 1.4.6 Productivity 39 viii Contents 1.5 The Portfolio Balance Approach 41 Example 42 1.6 Summary 43 2 Currency Economics: A More Focused Framework 47 2.1 Currencies are Different 48 2.1.1 (In)Efﬁcient Markets 48 2.1.2 Speculation and Exchange Rates: Cause, Effect and the Cycle 49 Example 50 2.1.3 Risk Appetite Indicators and Exchange Rates 53 2.2 Currency Economics 57 2.2.1 The Standard Accounting Identity for Economic Adjustment 58 Example1 59 Example2 60 2.2.2 The J-Curve 62 Example 62 2.2.3 The Real Effective Exchange Rate 63 2.3 Summary 63 3 Flow: Tracking the Animal Spirits 65 3.1 Some Examples of Flow models 69 3.1.1 Short-Term Flow Models 70 3.1.2 Medium-Term Flow Models 77 3.1.3 Option Flow/Sentiment Models 82 3.2 Speculative and Non-Speculative Flows 83 3.3 Summary 84 4 Technical Analysis: The Art of Charting 85 4.1 Origins and Basic Concepts 85 4.2 The Challenge of Technical Analysis 86 4.3 The Art of Charting 87 4.3.1 Currency Order Dynamics and Technical Levels 87 4.3.2 The Study of Trends 90 4.3.3 Psychological Levels 90 4.4 Schools of (Technical) Thought 100 4.5 Technical Analysis and Currency Market Practitioners 102 Part Two Regimes and Crises 105 5 Exchange Rate Regimes: Fixed or Floating? 107 5.1 An Emerging World 108 5.2 A Brief History of Emerging Market Exchange Rates 109 1973–1981 109 1982–1990 109 1991–1994 109 1995– 109 Contents ix 5.2.1 The Rise of Capital Flows 110 5.2.2 Openness to Trade 111 5.3 Fixed and Pegged Exchange Rate Regimes 111 5.3.1 The Currency Board 112 5.3.2 Fear and Floating 112 5.3.3 The Monetary Anchor of Credibility 113 5.4 Exchange Rate Regime Sustainability—A Bi-Polar World? 114 5.5 The Real World Relevance of the Exchange Rate Regime 116 5.6 Summary 118 6 Model Analysis: Can Currency Crises be Predicted? 119 6.1 A Model for Pegged Exchange Rates 120 6.1.1 Phase I: Capital Inﬂows and Real Exchange Rate Appreciation 120 6.1.2 Phase II: The Irresistible Force and the Moveable Object 121 6.1.3 Phase III: The Liquidity Rally 123 6.1.4 Phase IV: The Economy Hits Bottom 124 6.1.5 Phase V: The Fundamental Rally 125 6.2 A Model for Freely Floating Exchange Rates 128 6.2.1 Phase I: Capital Inﬂows and Real Exchange Rate Appreciation 128 6.2.2 Phase II: Speculators Join the Crowd—The Local Currency Continues to Rally 128 6.2.3 Phase III: Fundamental Deterioration—The Local Currency Becomes Volatile 129 6.2.4 Phase IV: Speculative Flow Reverses—The Local Currency Collapses 130 6.3 Summary 133 Part Three The Real World of the Currency Market Practitioner 135 7 Managing Currency Risk I—The Corporation: Advanced Approaches to Corporate Treasury FX Strategy 137 7.1 Currency Risk 138 7.2 Types of Currency Risk 140 7.2.1 Transaction Risk 140 7.2.2 Translation Risk 140 Example 141 7.2.3 Economic Risk 142 7.3 Managing Currency Risk 143 7.4 Measuring Currency Risk—VaR and Beyond 143 7.5 Core Principles for Managing Currency Risk 144 7.6 Hedging—Management Reluctance and Internal Methods 146 7.7 Key Operational Controls for Treasury 147 7.8 Tools for Managing Currency Risk 148 7.9 Hedging Strategies 150 7.9.1 Hedging Transaction Risk 150 7.9.2 Hedging the Balance Sheet 150 x Contents Example 151 7.9.3 Hedging Economic Exposure 152 7.10 Optimization 152 7.11 Hedging Emerging Market Currency Risk 153 7.12 Benchmarks for Currency Risk Management 154 7.13 Budget Rates 154 7.14 The Corporation and Predicting Exchange Rates 155 7.15 Summary 156 8 Managing Currency Risk II—The Investor: Currency Exposure within the Investment Decision 157 8.1 Investors and Currency Risk 157 8.2 Currency Markets are Different 158 8.3 To Hedge or not to Hedge—That is the Question! 159 8.4 Absolute Returns—Risk Reduction 159 8.4.1 Passive Currency Management 160 8.4.2 Risk Reduction 160 Example 161 8.5 Selecting the Currency Hedging Benchmark 161 Example 162 8.6 Relative Returns—Adding Alpha 163 8.6.1 Active Currency Management 163 8.6.2 Adding “Alpha” 163 8.6.3 Tracking Error 165 8.7 Examples of Active Currency Management Strategies 166 8.7.1 Differential Forward Strategy 166 8.7.2 Trend-Following Strategy 167 Example 169 8.7.3 Optimization of the Carry Trade 169 8.8 Emerging Markets and Currency Hedging 171 8.9 Summary 173 References 173 9 Managing Currency Risk III—The Speculator: Myths, Realities and How to be a Better Currency Speculator 175 9.1 The Speculator—From Benign to Malign 175 9.2 Size Matters 179 9.3 Myths and Realities 179 9.4 The Speculators—Who They Are 180 9.4.1 Interbank Dealers 180 9.4.2 Proprietary Dealers 181 9.4.3 “Hedge” Funds 182 9.4.4 Corporate Treasurers 183 9.4.5 Currency Overlay 184 9.5 The Speculators—Why They Do It 185 9.6 The Speculators—What They Do 185 9.6.1 Macro 186 Contents xi 9.6.2 Momentum (and Fellow Travellers) 186 9.6.3 Flow 187 9.6.4 Technical 187 9.7 Currency Speculation—A Guide 187 9.8 Summary 190 10 Applying the Framework 193 10.1 Currency Economics 193 10.2 Flow Analysis 193 10.3 Technical Analysis 194 10.4 Long-Term Valuation 195 10.5 The Signal Grid 195 10.6 Risk Appetite Indicators 195 10.7 Exchange Rate Regimes 196 10.8 Currency Crises and Models 197 10.8.1 CEMC 197 10.8.2 The Speculative Cycle 197 10.9 Managing Currency Risk I—The Corporation 197 10.9.1 Types of Currency Risk 197 10.9.2 Internal Hedging 198 10.9.3 Key Operational Controls for Treasury 198 10.9.4 Optimization 198 10.9.5 Budget Rates 199 10.10 Managing Currency Risk II—The Investor 199 10.10.1 Absolute Returns: Risk Reduction 200 10.10.2 Selecting the Currency Hedging Benchmark 200 10.10.3 Relative Returns: Adding Alpha 200 10.10.4 Tracking Error 201 10.10.5 Differential Forward Strategy 201 10.10.6 Trend-Following Strategy 201 10.10.7 Optimization of the Carry Trade 202 10.11 Managing Currency Risk III—The Speculator 202 10.12 Currency Strategy for Currency Market Practitioners 202 10.12.1 Currency Trading 203 Example 203 10.12.2 Currency Hedging 206 Example 206 10.13 Summary 208 Conclusion 211 Index 215 @Team-FLY Acknowledgements In getting this book from the ﬁrst stage of an idea to the printed edition, I am greatly indebted to Sally Smith and Rachael Wilkie of John Wiley & Sons publishing company for the initial invitation to write on this topic and subsequently for their advice, encouragement and diligent editorial work. It is a pleasure to work with people as professional as these. GregEdwardsandEmmanuelAcar,expertsintheirrespectiveﬁeldsofcorporateandinvestor currency risk management, were kind enough to read Chapters 7–9 and make corrections, suggestions and constructive criticism, without which this work would have undoubtedly been the poorer. TJ Marta provided charts and good advice. Speciﬁc thanks must go to Anil Prasad for allowing me the time to complete the book. My deepest gratitude goes to my wife Tamara, for her patience, love and understanding while I attempted to write this book on top of a full-time job as a currency strategist. I am also as ever indebted to my father and to the memory of my mother, who battled to get me to read at an early age, an effort that successfully unleashed an avalanche of reading, inquiry and travel. What little or otherwise I have become is down to their dedication and love and a very simple rule—to fail is forgivable but to fail to try is not. More generally, and outside of the speciﬁc framework of this book, anyone’s knowledge of ﬁnancial markets is a reﬂection both of their experience and of their interaction with market participants. Theory is ﬁne but there is nothing like watching and listening how it is done at the sharp end. In my career, I have been fortunate enough to come across a broad spectrum of experts in their respective ﬁelds, in central banks, in dealing rooms and within government and international organizations. They in turn have been kind enough to give of their time and their views. Space, consistency and in some cases the respected need for anonymity require that these do not be named individually. Sufﬁce to say they know who they are and it is my pleasure and privilege to know them. Last but not least, I wish to thank the reader. Having served in many capacities in my career, in journalism, in business, in analysis and ﬁnally in banking, an abiding theme of mine has been to keep a clear focus on the most important person in whatever ﬁeld one is in—the client. Too many forget this most fundamental aspect of commerce. Thus, in this small way, I thank the reader for taking his or her time to examine the ideas I have presented here and trust that in some measurable way they feel they have beneﬁted from the experience. Biography Callum Henderson is head of Emerging EMEA Strategy for a leading US investment bank, based in London, responsible for Emerging EMEA research, FX and Fixed Income Strategy. A widely quoted authority on both emerging and currency markets, Mr Henderson has written articles for a number of leading ﬁnancial journals and given seminars around the world on global currency markets, in particular on currency crises. Mr. Henderson is the author of three previous books covering the Asian economic story, Asia Falling, China on the Brink (awarded Best Business Book of 1999 by the Library Journal of the U.S.) and Asian Dawn. Prior to his current position, Mr. Henderson was part of the Citibank FX Strategy team which has been top-ranked by leading publications, and Manager of FX Analysis – Asia for Standard & Poor’s MMS, based in Hong Kong and New York. Mr. Henderson holds a B.A. Honours in Politics, Economics and French and an M.A. in Middle East Politics and Economics. The views expressed in this book are those of the author and do not necessarily reﬂect those of his employer. @Team-FLY Introduction It is the largest and most important ﬁnancial market in the world. If you are in business or in ﬁnance, it affects just about everything you do, whether you like it or not, whether you know it or not. Along with the interest rate, it is the most important price of a free and open economy. It is the fuel of economic trade and liberalization and without it globalization would never have happened. It is also one of the least well understood markets outside of those who choose to follow it in whatever capacity of their profession. It is variously described as the “currency” or “foreign exchange” or “FX” market, and it can be maddening and frustrating, but if you are a senior corporate ofﬁcer or an institutional investor you are compelled to know what it is, how it works and how it affects you. It should be stated right at the beginning that this is a book targeted not at the ordinary man or woman on the street but at the currency market practitioners themselves, at those whose “ﬂows” are responsible for moving the market in the ﬁrst place. The aim of this book is a simple one—to help currency market practitioners, from corporate Treasurers and Chief Executives to hedge funds and “real money” managers, execute more prudent and proﬁtable currency decisions in their daily business. This is no small aim and it is certainly not taken lightly. There is of course already a rich literature on the subject of exchange rates, as many readers will no doubt be aware. When you took business courses or did an economics degree at whatever level you probably had to wade your way through several of these. Why then the need for yet another book on exchange rates? The frank answer is that I felt there was a gaping hole in that “rich” literature, a massive omission that was intolerable and had to be addressed. Simply put, few if any of these works appeared to be aimed at the actual people who would have to put the theory into practice and actually execute the currency market transaction. It was as if a bank had written a series of books not for its clients or customers but instead for its own private, intellectual interest. The vast majority of the existing literature on exchange rates appeared to have been written from a very academic or theoretical perspective. To be sure, there are notable exceptions and in any case there is absolutely nothing wrong with academic theory. Few of these however went the extra mile and explained how to translate the theory into currency investing or hedging strategies. My aim here therefore is to address this “gaping hole” and try and do a better job of explaining both currency market theory and practice from the perspective of being a market participant myself, albeit in an advisory capacity. Thecurrencymarketisnotjustmyjob.Itisapassionandinterestofmineandhasbeensofor many years now. I started covering it in 1991 as a journalist in the run up to the Sterling crisis 2 Currency Strategy the subsequent year and “Black Wednesday”, September 16, 1992, when the UK currency was forced out of the Exchange Rate Mechanism (ERM) and promptly collapsed in value. The abiding memory of mine to this day is of the sheer power of the currency market in its ability to “defeat” the might and resolve of such a respected central bank as the Bank of England, which gave everything it had in its effort to defend sterling’s ERM “ﬂoor” against the Deutschmark of 2.7778. It is a memory of currency dealers screaming down the phone, of wave after wave of ofﬁcial intervention to support sterling being swatted aside by the sheer weight of selling pressure. The lesson of this neither is nor should be that ﬁnancial markets will out in all cases. Rather, it is that the currency market has become so huge that it simply cannot be resisted for any length of time. In the case of “Black Wednesday”—or “White Wednesday” as many would have it subsequently—the UK economy was experiencing a severe recession and thus simply could not tolerate the raising of UK interest rates needed to support sterling and keep it within its ERM band commitment. The economic pain of this interest rate and exchange rate commitment was completely at odds with the economic reality in the UK at that time. Moreover, UK foreign exchange reserves were fast being wiped out in that defensive effort. In 1992, the global currency market’s daily turnover was the equivalent of USD880 billion, according to the Bank of International Settlements (BIS) tri-annual survey. Thus, the Bank of England’s ability to intervene to support sterling, albeit in the billions, was dwarfed by the size of the forces opposing it. As of the 1998 BIS survey, daily turnover had increased to some USD1.5 trillion, subsequently falling back to USD1.2 trillion in the 2001 survey in the wake of the creation of the Euro. Needless to say, the Bank of England has certainly not been alone in its inability to defeat the power of the currency market. The following year, the remaining members of the ERM were forced under truly extraordinary pressure to abandon the narrow 2.25% bands required by the ERM commitment, widening them to 15%. On one day alone, on that Friday, July 30, before the weekend move to capitulate and widen the ERM bands, tens of billions of dollar equivalent were expended in an ultimately futile attempt to support member curren- cies. Depending on your point of view, even the feared German central bank, the Deutsche Bundesbank had been defeated (though the sceptical maintain that its effort to save the ERM was at best half-hearted). Whatever the case, it was an important lesson; not least that the currency market can act with unparalleled force and ferocity if it is so impelled. There was of course the obvious question—why and how could such extraordinary events happen in the currency market, events that were certainly not predicted by economists and which sometimes did not appear justiﬁed by the “fundamentals”? Forme,asformanypeopleintheﬁeld,thattimewasthestartofajourney,ajourneyIsuspect without an ultimate destination. One remains forever a student and the capacity for being taken by surprise remains endless. As a senior currency strategist for a global investment bank, the losses that one can incur as a result of making forecasting or recommendation mistakes are not so much ﬁnancial as reputational, but for that I would argue they are no less painful. As a member of that relatively small group of individuals who for good or ill seek to forecast exchange rates and make currency recommendations, you live or die by your reputation. You do not have the luxury of resorting to vague rhetoric and that is indeed how it should be. Nonetheless, as anyone who has tried knows, forecasting exchange rates is both an educa- tional and a humbling business. A factor that is deemed a crucial market driver one minute may be spurned the next as irrelevant. Most attempts within economic “fundamental” analysis to analyse exchange rates are based on some form of equilibrium model, which presupposes that there is an ideal or an equilibrium level to which exchange rates will revert. While equilibrium Introduction 3 exchange rate models such as those that focus on Purchasing Power Parity (PPP), the mone- tary and portfolio approaches, and the external balance, real interest rate differentials and the Real Effective Exchange Rate (REER), are extremely useful when trying to predict long-term exchange rate trends, most have a relatively poor track record over a shorter time frame. They provide a framework for currency forecasting and analysis and alert the users of them to im- portant changes in the real economy and how those in turn might affect exchange rates over the medium to long term. For instance, economists would say that an appreciation of a currency’s REERvalueshouldeventuallycausedeteriorationinacountry’sexternalbalance,whichshould lead to a loss of export competitiveness and the eventual need for a REER depreciation of the exchange rate in order to offset that lost competitiveness. The most effective way of achieving this is through a depreciation of the nominal exchange rate (as in the one you use when you take a trip to France). For a corporate this may be an invaluable guide as to the long-term exchange rate trend, which they can use to determine the parameters of their budget rates and also to set a strategic hedging policy. What this does not do however is tell the user when these events are likely to happen. It can provide a framework, a corridor, but it is unable to be more speciﬁc. In short, such models are limited in their ability to forecast exchange rates over the period on which most currency market practitioners are focused—1 day to 3 months. Theeconomicsprofessionusuallydealswiththisinconvenienceinoneoftwoways—either by ignoring it or by dismissing short-term currency moves as “speculative” and therefore not capable of being predicted. It has long been my view that such a response was inadequate and that in order to study currency markets one might therefore have to include other disciplines, albeit within a single analytical framework. Indeed, where economics has for the most part failed to predict such short-term moves, other disciplines such as technical and capital ﬂow analysishavesucceeded.Granted,theirsuccessisnotperfect,butithasbeenmeasurablybetter. Furthermore, while it has to be stressed that such long-term valuation models are important and useful guides to long-term trends, they are ﬂawed as forecasting tools because the very concept of “equilibrium” is itself ﬂawed. Such a concept is a useful and logical construct, providing a framework around which economic analysis can be built and allowing one to focus on a ﬁnal outcome. The speciﬁcs of that ﬁnal outcome are likely to remain vague however. While an equilibrium model may be able to tell what the ﬁnal outcome is likely to be, it will not be able to tell you when that outcome will happen nor what might happen in the getting there, which might change or distort that outcome. Moreover, while the construct of equilibrium may well be close to academic hearts, it seems rarely evident in real life, which remains in a constant state of ﬂux. An equilibrium level relates to a point to which exchange rates, if they are temporarily divergent from it, will revert back. In other words, it relates to an ultimate destination, or a “ﬁnal outcome” as described above. Markets however are volatile and can ﬂuctuate widely. Yet markets are an expression of economic reality, which means that the economic reality itself ﬂuctuates. In turn, this means that the equilibrium level resulting from that economic reality also ﬂuctuates and instead of being a stationary, single, ﬁnal outcome is rather a moving target. In economic jargon, the equilibrium level of an exchange rate is both cause and effect of the present level of exchange rates, moving over time, such movement constantly reducing or increasing the present exchange rate’s over- or undervaluation relative to that equilibrium. This is not to say that trying to track an equilibrium exchange rate level is not an important exercise. Rather, it is to point out the practical limitations of such equilibrium- based exchange rate models. As well as examining the limitations of exchange rate models, it is also important to dis- pose right at the start with a few myths that surround ﬁnancial markets in general and more 4 Currency Strategy speciﬁcally the subject of this book, the currency market. Firstly, classical economic theory asserts that market practitioners are “objective”, that is they are completely independent of and are not affected by the market conditions in which they operate. Intuitively, we know this to be nonsense. An investor is not only directly affected by present market conditions such as liquidityandvolatilitybutalsobypastexperience.Pastsuccessesmaymakeourinvestorbolder in their future investment decisions, while past losses may make them much more cautious. As John Donne would have it, no man is an island, so the same is true for the market practitioner, who can both be affected by and can affect market conditions. In short, they are both cause and effect. We can see this with that most fundamental of economic principles, supply and demand. Here too, there is no “objectivity”. Each is affected by the other—and we know this because if it were not the case price trends could not happen. If they were completely independent of each other, supply would instantly match demand and vice versa, thus stopping a price trend before it had begun. Yet, this is not the case. Price trends across asset and currency markets can last for days, weeks, months or even years. Another widely held myth is that markets are perfectly “efﬁcient”. The suggestion here is that both information availability and distribution are perfect—that all market participants have equal access to available, market-moving information. Furthermore, the assumption of market efﬁciency is that all market participants are “rational” and are proﬁt-seeking. Like the suggestion of “objectivity”, this is also the stuff of nonsense. Information is widely and freely available, but neither its availability nor its distribution is perfect. Indeed, one could argue that the very purpose of currency market practitioners is to get information that others do not have. Equally, the very concept of being “rational” is a subjective one and open to interpretation. Further, currency dealers are “rational” to the extent that they are trying to make a proﬁt. However, cautious investors or corporate Treasurers who are seeking to manage their currency risk are not trying to make a proﬁt. Rather, they are trying to limit any possible loss from their original currency exposure. Central banks and Treasury departments, who also operate within the currency market, are also not for the most part proﬁt-seeking. Trying to impose an all-ﬁts-one approach to explaining exchange rates simply does not work. For this very reason, economics by itself has had mixed results at best in forecasting exchange rates. The dynamics of the currency market are different from other markets and this should be taken into account. As we have seen, equilibrium exchange rate models help to provide the framework and the direction for long-term exchange rate analysis, but they are for the most part incapable of being more speciﬁc or more accurate over a shorter time frame. In trying to forecast short- term exchange rate moves, it may be necessary to use other tools and even other analytical disciplines. Within this book, there are outside of economics four types of analysis that we will look at for this purpose: ﬂow, technical, risk appetite and market psychology. Depending on what kind of currency market practitioner you are, you may view one or more of these analytical disciplines with some scepticism. This is all to the good, for if someone is to use any form of analysis in their daily business they ﬁrst have to be convinced that it actually works. We will examine these types of analysis in detail in the ﬁrst four chapters of this book. For instance, market psychology may be thought of as an excessively vague concept incapable of serious analysis or use, yet this is precisely what the ﬁeld of “behavioural ﬁnance” seeks to explain. How else to explain the fact that political events that do not materially affect economic fundamentalscanhavelastingimpactonexchangerates,wereitnotforthefactthatsuchevents changed the “psychology” or “sentiment” of the market? In early 1993, the then US Treasury Secretary Lloyd Bentsen was reported as saying that the Japanese yen was undervalued. This Introduction 5 statement and others after it led the market to believe that the US was deliberately seeking to devalue the US dollar against the yen in order to reduce the huge US–Japan trade deﬁcit. Whatever the reality, the market convinced itself that this was the case and for two years after that statement the yen rose inexorably against the US dollar. Did economic “fundamentals” play a part? Of course they did. Japan’s huge trade and current account surpluses with the US meant that for the dollar–yen exchange rate to remain stable Japan had to export to the US the same amount of capital through its capital account deﬁcit. At times when this was not the case, the yen was bound to appreciate and so it transpired. The trigger, the catalyst for this subsequent yen appreciation was however a change in market sentiment or psychology—and it took another change in market sentiment resulting from the new US Treasury Secretary Robert Rubin’s call for an orderly reversal of the dollar weakness for that yen appreciation to reverse. The subject of technical analysis also draws mixed reactions. While widely followed by currency dealers and the leveraged fund community, many corporate ofﬁcers and investors appear to regard it with scepticism—and many economists look on it as some form of voodoo orwitchcraft.Yettechnicalanalysisor“charting”hasastrongfollowingnotforanyideological reason, but simply because it “works”. Like any other form of analysis, there are technical analysts who are highly regarded by the market for their accuracy in meeting their forecasts, andthosethatarelesssuccessful.Theappealingthinghoweverformanymarketpractitionersis that technical analysis has targets at all. While there are important exceptions, too many within the economics profession remain content to talk eloquently if vaguely, attaching a multitude of caveats and in sum coming to no conclusion whatsoever. Needless to say, decisions on whether or not to hedge or invest cannot tolerate such imprecision. Where the strength of equilibrium exchange rate models is in providing a long-term exchange rate view, the strength of technical analysis is in predicting the timing of currency moves. In particular, it can be especially effective in predicting when those fundamentally-based long-term trends may take place. A more recent addition, at least in its present form, to this group of short-term analytical disciplines is “ﬂow” analysis, which involves the tracking of a bank’s client ﬂows, again for the purpose of forecasting short-term exchange rate moves. The benchmark ﬂow analysis product within the industry has been for some time CitiFX Flows. The ﬁeld of behavioural ﬁnance has undertaken considerable research into behavioural patterns such as investor herding, which can both be responsible for accelerating short-term trends and also for reversing them. The broad rule of such trends is that the longer they continue the more they become self-fulﬁlling. This is of course how ﬁnancial bubbles develop, in whatever kind of market. As the old adage goes, when you ﬁnd your taxi driver giving you stock tips, it’s probably time to get out of the market! We shall look at this recent yet intriguing discipline of ﬂow analysis later in the book. Most works to date on exchange rates rely purely on “fundamental” analysis, falling back on the traditional exchange rate models. While several of these are notable, most would appear to comeupshortontwogrounds.Firstly,theyfailtoaddresstheissueoftheforecastinginaccuracy of those models. Secondly, few have included other analytical disciplines to try to improve on thatforecastinginaccuracy.Crucially,fewhavetriedtoseeexchangeratesfromtheperspective of the end user of analysis or the currency market practitioner. For those who trade, invest or hedgeinthecurrencymarket,thebottomlineisindeedthebottomline.Fundamentaleconomic analysis is the means, it is not the end. A key aim of this book is to include other analytical disciplines and also to use a more currency-focused form of economic analysis or as I term @Team-FLY 6 Currency Strategy it “currency economics”, both for the purpose of trying to improve currency forecasting and recommendation accuracy. Using these various disciplines, I would recommend that currency market practitioners adopt an integrated approach towards currency forecasting and strategy that is both rigorous and ﬂexible. Equilibrium exchange rate models should still be used as the guide for short-term exchange rate trends, but for short-term moves a combination of currency economics, ﬂows, technical analysis, risk appetite and market psychology should be used. Therefore, at its most ambitious this book, Currency Strategy: The Practitioner’s Guide to Currency Investing, Hedging and Forecasting seeks to provide a new and more focused framework for currency analysis and thereafter to apply it to the decision-making process of the currency market practitioner themselves. The fact that the currency market affects just about every aspect of our economic life is a relatively recent phenomenon. Before 1971–1973, when the Bretton Woods system of pegged exchange rates, which had lasted since 1944, ﬁnally collapsed, you would have been laughed at if you had suggested as much. Currency risk was not a primary consideration. Indeed, the last 30 years have marked the ﬁrst time in monetary history that all major currencies have been freely ﬂoating and completely independent of some commodity peg. You could say as a result that we are living in a time of monetary experiment, an experiment which remains the subject of great controversy and debate as to whether or not it has been beneﬁcial or harmful. For my part, I nail my colours to the mast from the outset. I am an unequivocal, unashamed proponent offreetradeandfreecapitalmarkets.Thereislittledoubtthatfreeandopencompetitioncarries with it a harsh discipline. Yet, just as there are ﬂaws with that other experiment, democracy, so it can be measured only on a relative basis; that is, it is the worst option, apart from all the rest. Attempts at subsidizing the economy have clearly failed, thus for now free trade and capital markets reign supreme until such time as better alternatives come along. The currency markets are the fuel within the engine of globalization, an experiment that provides the liquidity for the world’s markets. That experiment began more precisely on August 15, 1971 when US President Richard Nixon announced that the US was abandoning its convertibility commitment between the value of the US dollar and gold at the rate of USD35 per ounce of gold. A diplomatic band- aid was subsequently attempted in December 1971 in the form of the so-called “Smithsonian Agreement”, but the attempt to keep major exchange rates pegged and shackled ﬁnally col- lapsed in March 1973. As with the ERM crises of 1992 and 1993, the cost of defending a currency peg that was incapable of responding to economic changes was eventually viewed as intolerable. The 1971–1973 period was unquestionably the seminal turning point in the development of the currency markets. Subsequently, there were historical events of varying importance, not least the development of the European Monetary System or the “Snake” which was succeeded by the ERM, the various oil crises, the Plaza and Louvre Accords of 1985 and 1987 respectively, and the coordinated G7 effort to achieve an “orderly reversal” of dollar weakness from 1995 onwards. None of these however carried the same weight as that of the second most important event in the recent life of the currency markets, the break-up of the Soviet Union and the ending of the Cold War. The coming to power in the Soviet Union of Mikhail Gorbachev in 1985 was a momentous event, the effects of which are arguably still being felt to this day. Glasnost and perestroika were primarily viewed as political doctrines of change, but they also reﬂected signiﬁcant economic change and not just for the Soviet Union. The tearing down of the Berlin Wall and the ending of the Soviet occupation of Eastern Europe marked the end of an era of hostility, conﬂict and subjugation, but it also marked the Introduction 7 beginningofthetearingdownofglobaltradeandcapitalbarriers.Thecompetitionofthefuture wouldnotbewitharms,butinsteadwithtradeandeconomiccompetitiveness.Thismostrecent phase of globalization is widely thought of as only being three or four years old, but it dates further back to those heady days of hope in the late 1980s, when all things seemed possible and the prospect of “mutually assured destruction” through nuclear confrontation between the US and the Soviet Union was ended. Purists will argue that there have been previous examples of globalization, notably around the beginning of the twentieth century, an experiment that as we all know ended badly, but for our purposes we focus only on this more recent exercise. The breaking down of those barriers—ﬁrstly those made of brick and subsequently those economic barriers to free markets—triggered an explosion in trade and capital ﬂows, which in turn triggered a parallel explosion in the size of the currency market as the BIS surveys from 1989 to 2001 conﬁrm. At a daily turnover of around USD1.2 trillion a day, the currency market now dwarfs the US stock or bond markets. As the pulling down of trade and capital barriers has led to investors and corporations seeking to expand and diversify in other countries, so the global currency market has been the facilitator of that, and in the process increased in size exponentially. When the experiment began in late 1971, most economists viewed favourably this new- found exchange rate ﬂexibility. Subsequently, to some, the experiment that started 30 years ago appears to have created a monster. The last decade in particular has seen much talk of a need to bring exchange rates back under control, either through a tax on currency trading (the so-called “Tobin Tax” idea) or a move to re-peg exchange rates, perhaps even using gold as the monetary anchor. From my perspective, while exchange rate volatility is frequently unwanted, empirical studies have noted that over the long term it is lower than equity market volatility and few are trying to shackle similarly the equity markets. Equally, the explosion the world has seen in trade, ﬁnance and most of all growth simply would not have taken place were it not for the currency market, acting as the facilitator of that growth. Whatever one’s view on the matter, there is no debate as to the global effect the currency market now has, nor that currency risk is now a crucial consideration. At the level of the ordinary man or woman on the street, the most obvious expression of this is through travel. When travelling abroad, most people consciously or subconsciously translate “foreign” prices backintotheirhomecurrencytermstogivethemaframeofreference.Thus,thepriceofforeign goods can seem “cheap” or “expensive” relative to the price of the same good in the home country. Economic models can be more effectively explained sometimes through example and analogy rather than through complex mathematical formulae. For instance, Americans generally regard the UK as “expensive”. If a New Yorker, who is used to paying a dollar ﬁfty for his morning cappuccino comes to London and has to pay three pounds sterling (USD4.5 at a sterling–dollar exchange rate of 1.5) the UK price is clearly expensive. In our example, the price differential reﬂects the sterling–dollar exchange rate, the relative supply/demand dynamics of cappuccino in New York and London and the different cost prices. The “law of one price” otherwise known as Purchasing Power Parity suggests that over time the exchange rate between two countries must alter so as to correct any imbalance between the price of the same basket of goods in those two countries. In our cappuccino example, if we use a cup of coffeeasreﬂectiveofthegeneralpricedifferentialforarepresentativebasketofgoodsbetween the US and the UK, a combination of a sterling depreciation over time against the dollar and a fall in the domestic London price of cappuccino relative to that in New York should occur in order to narrow the price differential. In theory, this works ﬁne over the long term. Readers will note that in 1992, the sterling–dollar exchange rate was brieﬂy above 2.00. At the start of 8 Currency Strategy 2002, it was around 1.45. Over the short term, however, the record of PPP is decidedly more patchy, which is of course no consolation to London coffee lovers nor to our New Yorker guest! Relative pricing can be further distorted by other factors such as barriers to trade and different cultural tastes. For instance, some people may not like coffee while to others it may be against their religion. That said, it holds true that the exchange rate is a key determining factor for how one deﬁnes “expensive” or “cheap” in the ﬁrst place. Thesamepremiseisalsoevidentatthecorporatelevel.WhentheUSdollarwasappreciating to multi-year highs against European currencies during the period of 1999–2001, this together withthefactofstrongUSconsumerdemandmadeitveryattractiveforEuropeanmanufacturers to export their production to the US at increasingly competitive prices. The strength of the US currency deﬂated the dollar price of these products, thus making them more competitive and encouraging US consumers to buy more European goods. For US exporters, however, the picture was the opposite, as their exports to Europe became less competitive as the dollar strengthened, reducing their market share or pricing them out of some markets entirely. Thus, the US trade deﬁcit ballooned, not just with Europe but with the world as a whole, reaching a level of some USD400 billion in 2001. Yet, just as the US trade deﬁcit was expanding, so more competitive exports to the US together with a slowdown in US demand in 2001 forced US manufacturers in turn to cut their prices, reducing inﬂationary pressures. However, as corporate executives are painfully aware, just as domestic currency weakness can lead to more competitive exports and thus higher proﬁts, causing a benign circle, so a vicious circle can result from domestic currency strength, hurting one’s export competitiveness. From the perspective of a European exporter, a weak dollar is not a good thing, as it causes the exporter’s prices to rise in dollar terms. At some stage, those higher prices will cause US consumers to buy American instead of European. This will cause the US trade deﬁcit with Europe to shrink, but it will also bite hard into the proﬁts of European exporters. Exporters are of necessity keenly aware of the importance of exchange rate movements. However, companies that have no exports but simply produce and sell in a single country are also affected. A company that has no direct export exposure and thus thinks itself blissfully exempt from currency risk is in for a nasty shock. As we have seen in the above example, changesintheexchangerate—theexternalprice—causechangesinturninthedomesticprice of goods and services. Thus, if your currency strengthens against that of your competition, you face a competitive threat—and assuming all else is equal, the choice of either cutting your prices, thus reducing your margin, or losing market share. Currency movements can also have a profound effect on investing. Fixed income and equity portfolio managers, in investing in another country’s assets, automatically take on currency exposure to that country. Frequently, fund managers view the initial decision to invest in a country as being one and the same with investing in that country’s currency. This is not nec- essarily the case for the simple reason that the dynamics which operate within the currency market are frequently not the same as those that govern asset markets. It is entirely possi- ble for a country’s ﬁxed income and equity markets to perform strongly over time, while simultaneously its currency depreciates. My favourite example of this phenomenon is that of South Africa. From the autumn of 1998, when the 5-year South African government bond yield brieﬂy exceeded 21%, this was one of the world’s most outstanding investments un- til November 2001. By then, this yield had made a low of around 9.25%, a direct and in- verse reﬂection of the degree to which its price soared over the previous three years. In that time however, the value of the South African rand has fallen substantially from around 6 to the US dollar to almost 14. Here is a clear example where the currency and the bond market Introduction 9 of the same country have been going in opposite directions over a period of three years! An investor in the 5-year South African government bond in the autumn of 1998 would have seen their excellent gains in the underlying ﬁxed income position over that time wiped out by the losses on the rand exposure. The lesson from this is that currency risk should be an important consideration for asset managers and moreover one that is managed separately and independently from the underlying. Empirical studies have shown that currency volatility reﬂects between 70 and 90% of a ﬁxed income portfolio’s total return. Thus, for the more conservative fund managers, who cannot take such swings in returns but do not take the pru- dent step of hedging currency risk, it can be the main reason why they stay out of otherwise proﬁtable markets. Conversely, currency risk can also enhance the total return of a portfolio. When the US dollar was falling from 1993 to 1995, this made offshore investments more attractive for US fund managers when translating back into dollars. It was no coincidence that this period also saw a substantial increase in portfolio diversiﬁcation abroad by this investment community. There is little doubt that currency exposure can be unpredictable, frustrating and infuriating, but it is not something one has the luxury of ignoring. In John Maynard Keynes’ reference to the “animal spirits”, that elemental force that drives ﬁnancial markets in herd-like fashion, he was referring to the stock market. More than most, he should have deﬁned such a term as he was one himself, having been an extremely active stock market speculator as well as one of the last century’s most pre-eminent economists. However, he might as well have been referring to the currency market, for the term sums up no other more perfectly. A market that is volatile and unpredictable, a market that epitomizes such a concept as the “animal spirits” surely requires a very speciﬁc discipline by which to study it. That is precisely what this book is aimed at doing; providing an analytical framework for currency analysis and forecasting, combining long-term economic valuation models with market-based valuation techniques to produce a more accurate and user-friendly analytical tool for the currency market practitioners themselves. In terms of a breakdown, the book is deliberately split into three speciﬁc sections with regard to the currency market and exchange rates: r rPart I (Chapters 1–4)—Theory and Practice Part II (Chapters 5 and 6)—Regimes and Crises rPart III (Chapters 7–10)—The Real World of the Currency Market Practitioner We begin this process with Chapter 1 (Fundamental Analysis: The Strengths and Weak- nesses of Traditional Exchange Rate Models) which as the title suggests examines the contribution of macroeconomics to the ﬁeld of currency analysis. As we have already seen brieﬂy in this Introduction, economics has created a number of equilibrium-based valuation models. Generally speaking, such models try to determine an equilibrium exchange rate based on the relative pricing of goods, money and trade. In turn, this concept of relative pricing can be broken down into four main types of long-term valuation model, which focus on international competitiveness, key monetary themes, interest rate differentials and the balance of payments. I would suggest that while such equilibrium exchange rate models are an indispensable tool for analysing long-term exchange rate trends, their predictive track record for short-term moves is mixed at best. Moreover, as we noted above, they are based on the concept of an equilibrium, which rarely exists in reality and if it does exist is in any case a moving target. This is in no way to attempt to downplay the immense contribution that economics has made to currency analysis,ratheritistoemphasizethedifferentfocusofthetwodisciplines.Whereaseconomics seeks to determine the “big picture”, currency analysis seeks speciﬁc exchange rate forecasts 10 Currency Strategy over speciﬁc time frames. Neither is “better” or “worse”. They are merely different analytical disciplines responding to a different set of requirements. In the very act of attempting practical modiﬁcations to the classical economic approach towards exchange rates, one pays homage to the original work. Preciselybecausecurrencymarketsareaffectedbysomanydifferentfactors,ithasprovedan extremely difﬁcult (if not impossible) task for economists to design fundamental equilibrium models with predictive capacity for exchange rates for anything other than the long term. Thus, Chapter 2 (Currency Economics: A More Focused Framework) seeks to go beyond these theoretical models outlined in Chapter 1 to capture those elements of economics relevant to the currency market and tie them into a loose analytical framework capable of giving a more relevant and accurate picture of short- and medium-term currency market dynamics. Whereas theclassicaleconomicapproachhasbeentostartwithgeneraleconomicrulesandimposethem on exchange rates, the emphasis here is to start with the speciﬁc currency market dynamics and use whichever aspects of economics are most appropriate to these, as characterized by the label “currency economics”. The attempt here is not to create or deﬁne a new economic discipline, but instead to use the existing qualities of economic and other analytical disciplines to create a framework of exchange rate analysis that is more relevant and useful for currency market practitioners. Forthispurpose,wecannotrelyoneconomicsalone.Asweanalysethespeciﬁcdynamicsof the currency market we see that other analytical disciplines may also be relevant. In Chapter 3 (Flow: Tracking the Animal Spirits) we look at the ﬁrst of these, namely that of “ﬂow” analysis. It is interesting to note that where once this discipline was not even recognized as having worth, it is now at the forefront of ﬁnancial analysis. As barriers to trade and capital have fallen over the last three decades, so the size and the importance of investment capital has grown exponentially. While the classical approach has traditionally taken the view of the efﬁcient market hypothesis, namely that information is perfect and that past pricing holds no relevance in a market place where all participants are rational a
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