Active Currency Management Based on Economic Fundamentals
This approach assumes that, in the long term, currency value will converge to fair value. For example, a fundamental approach may assume purchasing power parity will determine long-run exchange rates.
Several factors will impact the eventual path of convergence over the short and intermediate terms.
All else equal, the base currency’s real exchange rate should appreciate if there is an upward movement in
- its long-run equilibrium real exchange rate;
- either its real or nominal interest rates, which should attract foreign capital;
- expected foreign inflation, which should cause the foreign currency to depreciate; and
- the foreign risk premium, which should make foreign assets less attractive compared with the base currency nation’s domestic assets.
Opposite conditions are believed to be associated with declining currency values.
Interaction of Long-term and Short-term Factors in Exchange Rates
Active Currency Management Based on Technical Analysis
Technical analysis of currency is based on three principals:
- Past price data can predict future price movement and because those prices reflect fundamental and other relevant information, there is no need to analyze such information.
- Fallible human beings react to similar events in similar ways and therefore past price patterns tend to repeat.
- It is unnecessary to know what the currency should be worth (based on fundamental value); it is only necessary to know where it will trade.
Technical analysis looks at past price and volume trading data. FX technical analysis focuses on price trends as volume data is generally less available. Technical analysis works best in markets with identifiable trends. Typical patterns that technicians seek to exploit are the following.
- An overbought (or oversold) market has gone up (or down) too far and the price is likely to reverse.
- A support level exists where there are substantial bids from customers to buy. A price that falls to that level is then likely to reverse and bounce higher as the purchases are executed.
- A resistance level exists where there are substantial offers from customers to sell. A price that rises to that level is then likely to reverse and bounce lower as the sales are executed.
At both support and resistance levels, the price becomes “sticky.” However, if the market moves through the sticky resistance levels, it can then accelerate and continue in the same direction.
Moving averages of price are often used in technical analysis. A common rule is that if a shorter-term moving average crosses a longer-term moving average, it triggers a signal. The 50-day moving average rising above the 200-day moving average is a buy signal, falling below is a sell signal.
Active Currency Management Based on the Carry Trade
A carry trade refers to borrowing in a lower interest rate currency and investing the proceeds in a higher interest rate currency. Three issues are important to understand the carry trade.
- Covered interest rate parity (CIRP) holds by arbitrage and establishes that the difference between spot (S0) and forward (F0) exchange rates equals the difference in the periodic interest rates of the two currencies.
- The currency with the higher interest rate will trade at a forward discount, F0 < S0
- The currency with the lower interest rate will trade at a forward premium, F0 > S0
- The carry trade is based on a violation of uncovered interest rate parity (UCIRP). UCIRP is an international parity relationship asserting that the forward exchange rate calculated by CIRP is an unbiased estimate of the spot exchange rate that will exist in the future. If this were true:
- The currency with the higher interest rate will decrease in value by the amount of the initial interest rate differential.
- The currency with the lower interest rate will increase in value by the amount of the initial interest rate differential.
- Because the carry trade exploits a violation of interest rate parity, it can be referred to as trading the forward rate bias. Historical evidence indicates that:
- Generally, the higher interest rate currency has depreciated less than predicted by interest rate parity or even appreciated and a carry trade has earned a profit.
- However, a small percentage of the time, the higher interest rate currency has depreciate substantially more than predicted by interest rate parity and a carry trade has generated large losses.
Generally, the carry trade is implemented by borrowing in the lower interest rate currencies of developed economies (funding currencies) and investing in the higher interest rate currencies of emerging economies (investing currencies). In periods of financial stress, the currencies of the higher risk emerging economies have depreciated sharply relative to the currencies of developed economies and such carry trades have generated significant losses. Given that periods of financial stress are associated with increasing exchange rate volatility, traders often exit their carry trade positions when exchange rate volatility increases significantly.
To show the equivalence of the carry trade and trading the forward rate bias, recall that covered interest rate parity (which is enforced by arbitrage) is stated as:
Summary of the Carry Trade
| The Carry Trade: | ||
|---|---|---|
| Is implemented by: | Borrowing and then selling in the spot market the lower yield currency. | To buy and invest in the higher yield currency. |
| Is trading the forward rate bias: | Selling in the spot market the currency trading at a forward premium. | And buying in the spot market the currency trading at a forward discount. |
Active Currency Management Based on Volatility Trading
Volatility or “vol” trading allows a manager to profit from predicting changes in currency volatility. Recall from Level I and Level II that delta measures the change in value of an option’s price for a change in value of the underlying and that vega measures change in value of the option for changes in volatility of the underlying. Vega is positive for both puts and calls because an increase in the expected volatility of the price of the underlying increases the value of both puts and calls.
Delta hedging entails creation of a delta-neutral position, which has a delta of zero. The delta-neutral position will not gain or lose value with small changes in the price of the underlying assets, but it will gain or lose value as the implied volatility reflected in the price of options changes. A manager can profit by correctly predicting changes in volatility.
A manager expecting volatility to increase should enter a long straddle by purchasing an at-the-money call and put. The manager is buying volatility. The two options will have equal but opposite deltas making the position delta neutral. If volatility increases, the options will rise in net value and the trade will be profitable.
A manager expecting volatility to decrease should enter a short straddle by selling both of these options. If volatility declines, the options will fall in net value. The options can be repurchased at lower prices for a profit.
A strangle will provide similar but more moderate payoffs to a straddle. Out of-the-money calls and puts with the same absolute delta are purchased. The out-of-the-money options require larger movement in the currency value to create intrinsic value but will cost less. Both the initial cost and the likely profit are lower than for the straddle.