home currency at spotrates or (b) yen returns hedged to the home currency by forward contracts.This may appear to be a little academic in the short run, but it is not academic at all in thelong run. Under alternative (a), we are looking at a combination of currency spot exchangerate movements and equity returns. Under alternative (b), we are looking at only equityreturns, with the effect of exchange rates eliminated.If a US investor was to report the performance of the Nikkei for 20 years (say Dec1981–Dec 2001), the index has gone from 7681.8 to 10 542.62, a rise of 37.2% or 3.2%p.a. But if a US investor had invested in the Nikkei in Dec 1981, and hedged the currencyexposure to eliminate any effect of the yen spot rate, then the rise would have been 140.7%or 9.2% p.a. This is a very signiﬁcant difference, and illustrates the importance of avoidinglocal-currency-denominated equity market analysis over anything but the shortest term.This means that the realisable performance of any index is different depending on thebase currency from which one views it. The 20-year Nikkei numbers shown above can berecalculated for a UK investor, and the effect is even more marked. A rise of 37.2% in localcurrency converts to a rise of 236.5% when expressed in sterling (and excluding exchangerate movements). This would mean the Nikkei, which stood at 7681.8 in Dec 1981 wouldbe 25 852.3 for a sterling investor rather than the 10 542.6 that is reported in yen. Thefollowing graph illustrates this:Nikkei expressed in yen and hedged sterling60 000
Nikkei (rebased for sterling)
Nikkei
50 000
Nikkei rebased to hedgedsterling
40 00030 00020 00010 000-
82
84
86
88
90
92Year
94
96
98
00
02
Currency Hedging
57
Why is this methodology so compelling? Because an investor can only measure return seriesagainst alternative return series that are available. Since the alternative to investing in currencies(strictly speaking currency exposure) is not investing in currencies, the currency return seriesmeasured must be one that can be eliminated.The importance of this methodology cannot be underestimated, nor the very substantial impact of interest rate differentials on long-term currency trends. Many investors have a distortedview of a particular currency’s ‘strength’ or ‘weakness’ because they only look at the headlinerate – the spot rate. Box 3.8 graphically illustrates the point.
3.6.4 Geometric linking and ‘adding across’All the cumulative ﬁgures are derived by geometrically linking the period returns. The readerwill note that while period returns can be accurately ‘added across’ (since the percentageshave the same base), multi-period returns appear not to be. This needs some analysis andexplanation.The way in which period returns can be cumulated, and how they can then be ‘added across’,depends crucially on the underlying nature of the combinations. There are three main typesof ‘asset combination types’, and therefore three different ways of combining returns. Let ussuppose we are talking about two return series; for simplicity, returns (a) and (b) in Table 3.13.
3.6.4.1 Assets in a portfolioIf a portfolio consists of two assets, (a) and (b), then their returns are combined by adding theunderlying values, and then recalculating the returns from the combined values. In this example(Table 3.14), the assets are equally weighted at the beginning of the cumulating period, i.e.period 0.Now if we just look at the three return series (Table 3.15), we can see that the period-byperiod portfolio returns are ‘arithmetically averaged across’ as well as combined geometricallydown. This is intuitively straightforward, and certainly convenient when dealing with returnsat various levels in the portfolio.
Table 3.14 Returns in a two-asset portfolio
Endperiod012345Cum.
Asset A
Asset B
(a) = (ct /ct−1 ) −1 (b) = (dt /dt−1 ) −17.14%18.46%−8.08%5.61%−5.70%16.20%
5.10%5.50%−6.07%−5.84%−3.60%−5.46%
AssetAssetvalue A value B(c)
(d)
50.0053.5763.4658.3361.6158.10
50.0052.5555.4452.0849.0447.27
Portfoliovalue
Portfolioreturn (%)
(e) = c + d (f) = (et /et−1 ) −1100.00106.12118.90110.41110.64105.37
6.12%12.04%−7.14%0.21%−4.77%5.37%
58
Currency OverlayTable 3.15 ‘Adding across’ a two-asset portfolio
Endperiod012345Cum.
Returnasset A (%)
Returnasset B (%)
Portfolioreturn (%)
Weighted average
(a)
(b)
(c)
(d) = weighted a + weighted b
7.14%18.46%−8.08%5.61%−5.70%16.20%
5.10%5.50%−6.07%−5.84%−3.60%−5.46%
6.12%12.04%−7.14%0.21%−4.77%5.37%
6.12%12.04%−7.14%0.21%−4.77%5.37%
3.6.4.2 International assets and the spot rateThe position gets more complicated when the two return series being evaluated are the localcurrency asset value and the spot rate. If we go back to Table 3.9, (reproduced as Table 3.16),we see not only that column (e) is the percentage change in the sterling value of the assets, butalso that it can be calculated by geometrically linking (not arithmetically averaging) across thetable the two returns, e.g. for period 2, 10% and 7.69% are combined as follows: 18.46% =[(1 + 0.1) × (1 + 0.769)] − 1.Table 3.16 Combining equity & spot currency returns
Endperiod012345Cum.
Equityvalue ($m)
Equityreturns
Spotrate
(a)
(b) = (at /at−1 ) −1
(c)
10101110.511.511
0.00%10.00%−4.55%9.52%−4.35%10.00%
1.50001.40001.30001.35001.40001.4200
Spotreturns
Combined equity &spot returns
(d) = (ct−1 /ct ) −1 (e) = [(at /ct )/(at−1 /ct−1 )] −17.14%7.69%−3.70%−3.57%−1.41%5.63%
7.14%18.46%−8.08%5.61%−5.70%16.20%
The spot rate and the local currency are virtually the only variables in investment management that are combined in this way. This is because of the nature of these return series andtheir valuation – currency has a ‘multiplicative’ relationship with underlying investments, notadditive. The cumulative returns are also geometrically linked both across and down, so thespot rate, despite being uninvestible, has a fully multiplicative relationship with the underlyinginternational investment.3.6.4.3 Assets and overlay/hedgingThis tidy state of affairs is now to be contrasted with the maths associated with overlay (orhedging – in this context it is the same) (and also with attribution analysis).
Currency Hedging
59
Currency overlay is not multiplicative at the single period level – it is (as indicated by themaths of the hedged return above) additive. However, currency overlay is not an asset. Youcannot put £100 into ‘currency overlay’ and receive returns each period which will compoundup. Currency overlay is a source of a variable return which does not have a capital allocation.This means that currency overlay/currency hedging returns cannot be geometrically linkedalone.Geometric linking is the universal linking method for period-by-period returns, but it assumes that the full value of the asset at any period-end is available for reinvestment at the nextperiod-start (which is simultaneous). Linking assumes that there is a ‘carrier’ investment withsome starting value which can be increased or reduced by the amount of each period return.There is no such automatic ‘carrier’ investment in currency overlay or hedging. However, thereare carrier investments which are commonly associated with overlay – in particular, and ratherobviously, international assets. Once we have a ‘carrier’ asset, then we can geometrically link.Let’s take an example from the data above. Table 3.17 is a ‘cut down’ version of Table 3.12,which has the relevant information. The question that we would like to answer is: what is thecontribution from currency hedging over time? There are at least three answers to this – noneof which is indisputably right, and one of which is wrong. Let’s start with the wrong one.Table 3.17 Hedged equity return calculationEnd period012345Cum.
Equity value (£m)6.677.148.467.788.217.75
Unhedged equityreturn (%)
Currency hedgeproﬁt/loss (%)
Hedged equityreturn (%)
7.14%18.46%−8.08%5.61%−5.70%16.20%
−5.10%−5.50%6.07%5.84%3.60%4.30%
2.04%12.96%−2.01%11.46%−2.10%23.24%
Geometric linking: The value reported (in italics) in the cumulative row under the ‘currencyhedge proﬁt/loss’ – 4.30% – is the geometrically linked value of the period hedge return above.I have already described above that this is an incorrect way to calculate it, but I have not yetspelt out in full the problem.At the end of period 1, the return from currency hedging is −5.10%. What does this mean?It means that in this context (1-month contracts), there is a cash outﬂow of 5.10% of theend-period value of the unhedged international asset – which is £6.67m. So 5.10% means anoutﬂow of −5.10% × £6.67m = −£0.34m. But the key here is that −£0.34m is 5.10% of theunhedged asset value, not of ‘itself’ a period earlier. What would it mean, therefore, to saythat the cumulative loss after two periods was {(1 −0.0510) × (1 −0.0550)} −1 = −10.32%?It would imply that the principal had shrunk in the ﬁrst period by 5.10%, and that thereforethe impact of the second loss would be reduced. This will not be true, since the 5.50% lossis a percentage of the end-period 1 unhedged asset value, which has gone up by 7.14%. Itmay be that the cash outﬂow from hedging at the end of period 1 was funded by a sale ofinternational equities (although in practice this is unlikely), but even if this was the case thiswould be accounted for in a performance measurement sense by the withdrawal of £0.34m
60
Currency Overlay
from the amount invested in equities. No percentage returns would change. The nature of thecalculation of currency hedging returns therefore rules out the geometric linking of stand-alonehedging.Interestingly, if the relative weight of country equities in an international portfolio is determined by the market-cap, this is universally measured by the unhedged market-cap. Thismeans that even if the rise in a country’s relative weight is due to currency movements, thiscountry will nevertheless keep that higher weight in the index, and therefore a fund would notrebalance the portfolio by selling that country’s equity alone to fund the hedging loss.Subtraction: A much more defensible way to report on the effect of hedging would be tosubtract the cumulative (geometrically linked) return of the hedged equities from the unhedgedequities. This gives the cumulative return of the hedging as 23.24% −16.20% = 7.04%. This isa materially different ﬁgure from 4.30%, and more accurately reﬂects the way currency hedginghas affected the return of the underlying securities. However, this value is also materiallyaffected by the return behaviour of the underlying securities – meaning that the overlay manageris in part dependent on the performance of the hedging he controls on underlying returns thatare entirely outside his control. For example, if the underlying security had exhibited zeroreturns over the period in question, the returns from hedging would have been 5.92% ratherthan 7.04%. There are no particular rules that govern this relationship – it depends on thedetailed period-by-period returns to determine the ‘interference’ effects. On balance, however,subtraction is a mathematically and intuitively appealing approach, and is to be recommended.The one word of caution is that the subtraction approach does require an underlying carrier,and that the choice of carrier will inﬂuence the currency hedging returns.Arithmetic: One ﬁnal alternative is available. This is to arithmetically average returns, andthen annualise using conventional geometric annualisation techniques. In this case we want thecumulative 5-period return, so let us suppose that the returns in Table 3.17 are monthly, thenthe cumulative return from hedging would be the arithmetic average of the monthly returns−0.98%, grossed up to 5 months by [(1 + 0.0098) ˆ 5] − 1 = 5.00%. Normally, longer serieswould be annualised (i.e. raised to the power 12).This is a fudge, but one with less stark faults than geometric linking. The fudge is thatannualising using powers is, in effect, geometric linking, which we saw earlier was ﬂawed.However, the practical effects of the ﬂaw are minimised by arithmetic averaging, because bythis method, the series is assumed to have constant return, which will avoid the large secondorder-generated errors of highly volatile return series.
4Foreign Exchange Market – Historyand Structure4.1 BRIEF HISTORY OF THE FOREIGN EXCHANGE MARKETAND HOW INSTRUMENTS DEVELOPED4.1.1 Bretton WoodsIn the reconstruction that followed the Second World War, the Bretton Woods Agreement became for nearly 30 years the guiding principle for the management of exchange rates and intergovernmental ﬁnancing. Bretton Woods was concluded in the belief that national governmentswere (or should be) overwhelmingly dominant in the conduct of national and internationalﬁnancial markets. It was also concluded in the belief that ﬁnancial markets alone were notcapable of lubricating the wheels of international trade and clearing the markets for currencies.This interventionist thinking found its source in the severe failure to clear of markets (particularly the labour market) in the 1930s, and developed to maturity with the seeming success ofallied (particularly British) interventionist policies in the Second World War.
4.1.2 Central banks as bufferIn July 1944, despite the still raging war, an intergovernmental conference of 43 (allied) countries met in a small town in New Hampshire, US – Bretton Woods. Their agenda was to establishinternational arrangements to prevent the competitive devaluations, trade wars and protectionism of the 1930s. The feeling amongst the participants was that the economic conditions of the1930s had bred fascism, and therefore ultimately war. The agreement that came out of BrettonWoods laid the foundations for two new institutions – the International Bank for Reconstructionand Development (IBRD), otherwise known as the World Bank, and the International Monetary Fund (IMF). The World Bank’s brief was to provide long-term ofﬁcial loans to facilitateeconomic development, mainly in the less developed economies, the IMF’s brief was to operatea system of controlled exchange rates and internationally co-ordinated monetary policies.One of the guiding principles of the IMF was the implicit acceptance that national governments had responsibility for balancing external supply and demand of their domestic currencywithout exchange rates providing an automatic stabiliser. In short, making up any current account shortfall from reserves or mopping up any current account surplus by foreign currencypurchases. In the world of the 1950s and 1960s, a world of credit controls, exchange controlsand little private cross-border capital ﬂows, this system worked tolerably well. Central banksdid not generally have to bow to market pressures, and governments could conduct domesticmonetary policy with virtually no external interference or linkage. There was broad exchangerate stability, punctuated by occasional realignments when persistent exchange deﬁcits depleted reserves too far. There was very little international liquidity outside the central banks,so that relatively modest foreign currency reserves were adequate to iron out most supply anddemand ﬂuctuations.
62
Currency Overlay
4.1.3 Ad hoc foreign exchange market developmentMost OECD countries emerged from the Second World War with stringent exchange controls,and these largely remained in place until well after the breakdown of ﬁxed exchange ratesin 1972/3. As a direct result of exchange controls, currency exchange arrangements wereossiﬁed in the structures dictated by central banks. Customers, usually commercial companiesor individuals, were forced to buy and sell their foreign currency through retail banks, whoeffectively had a monopoly. For many years, the business of foreign exchange was seen as an(expensive) irritant by customers, and as a sleepy but lucrative backwater by the retail banks. Inthe ﬁxed exchange rate environment of 1945–71, it was largely an administrative not a marketactivity.Box 4.1
Capital ﬂows
‘Capital ﬂows’ are often cited as a relevant factor in the determination of exchange ratesand exchange rate movements. But what are they? The expression is a loose one, and is usedby observers of the currency market to describe or explain the movements of funds acrossthe exchanges. Generally speaking, they have different meanings at different horizons. Letus take these in order.Short-term: A market commentator, usually speaking from a bank market-maker’s perspective, will talk about ‘strong ﬂows’ in a particular direction – say to sell euros/buydollars. What this generally means it that the bank’s customers have been executing dealsthis way round in a trading day, and the bank has had to go to the interbank market toﬁnd buyers of euros. This is sometimes associated with a falling euro price (‘it was all oneway’), and so, in the desire to ex post rationalise market movements, the ‘capital ﬂows’ outof the euro are described as having caused the price fall. Alternatively, it can be associatedwith stable or rising euro prices – in which case it is described as ‘strong two-way volume’.In reality, of course, there will have been no net capital movements; every sell order ofthe euro being matched with a countervailing buy order. The perception of capital ﬂows,therefore, is one of sectional interests and not about the whole market.Long-term: Although all unrationed markets clear with equal volumes of buyers andsellers, it is still possible to categorise types of economic agents into homogeneous units(or at least sufﬁciently homogeneous to be useful). So, for example, the Japanese public and private sectors have a seemingly inexhaustible appetite for US paper assets –particularly US Treasury securities. This ‘capital ﬂow’ has been extremely important inthe evolution not only of the yen/dollar exchange rate, but also of all the related exchangerates (i.e. anything with a yen or dollar in it). Understanding the behaviour of this group(or maybe two groups – public and private) may provide valuable insights into the futurebehaviour of the exchange rate. This type of thinking is very widespread in the foreignexchange markets – and much research goes into analysing and understanding capitalﬂows.
4.1.3.1 The ‘Euro-market’This settled state of affairs began to change in the late 1960s, and was given a massive spur atthe beginning of the 1970s with successive oil price rises which created for the ﬁrst time very
Foreign Exchange Market – History and Structure
63
large international liquidity. This sudden appearance of ‘hot’ money started the development ofthe huge, liquid and unregulated foreign exchange markets that we see today. For the ﬁrst timelarge unofﬁcial currency balances were held abroad. ‘Unofﬁcial balances’ were the proceedsof oil sales to the west by OPEC countries, and these were not controlled by central banks, butby commercial and quasi-state entities with commercial aims. The balances were in the majorOECD currencies (mainly dollars), and the scale of the net transfer of wealth to the OPECcountries was such that these balances were recycled back into the OECD economies. Thebalances were held in bank accounts (not even in securities) in offshore accounts (offshore toboth the OPEC owners and the issuers of the currency), and these balances were free to moveacross the exchanges unfettered by domestic exchange controls. This heralded the growth(mainly in London) of what has rather euphemistically been called the ‘Euro-market’,1 butwhich in reality was a black market. An abiding characteristic of ‘black’ or ‘unofﬁcial’ markets,however, is that they clear at prices that express the genuine balance of desires to buy and sellthe currency or commodity in question.
4.1.4 Free markets dominateThe scale of the new trading in the 1970s was sufﬁciently large that central banks no longerhad the whip-hand. The visible effect of this was the (rather disorderly) collapse of the BrettonWoods ﬁxed exchange rate agreement in 1972/3. Historical exchange rate series at this pointchanged from being straight horizontal lines with the odd discontinuity up or down, to thewobbly lines that look like the FX prices of today. The collapse also heralded the ﬁnal demiseof any practical link between the monetary system and gold, although formal arrangementslingered on, and are still highly visible 30 years later in the very large (but completely pointless)ofﬁcial reserves of gold held by the major central banks.2What in practice happened was that offshore (i.e. Euro) trading of pairs of non-domesticcurrencies became the price-setting mechanism, and domestic spot exchange rates had tofollow suit. If they did not, qualiﬁed economic agents like domestic banks who bridged thedomestic/Euro divide could otherwise exploit the arbitrage. A few tightly controlled anomaliesremained [like the sterling/dollar pool for external capital ﬂows (abolished in 1979)], butgenerally the free markets dominated.The subsequent 30 years have seen the explosive growth of the FX market, and the domination of this global free market model in the price-setting mechanism. One by one countryspeciﬁc protections have been dismantled, and most developed countries now have an exchangerate that is widely traded without restriction in this market. The US and EU economies havegone the farthest in embracing the global FX market, the Far East economies the least far.There remain pockets of resistance to this model, and at the most extreme (say in mainlandChina or Malaysia3 ), the local currency is effectively shut out of the global market by tightdomestic legal restrictions on permitted trading. See Section 4.4.1.1The use of the word ‘Euro’ in this context is unrelated to the new euro currency. It was coined initially by American bankers inthe 1960s who realised that trading US dollar-denominated securities and foreign exchange in London circumvented the regulatoryand tax hurdles erected at that time by the US government.2For those interested in the role of gold in central bank intervention, see Record, N. P., Central bank intervention: a new approach,Centre for the Study of Financial Innovation, London, Working Paper Series, November 1996.3Malaysia is an interesting case because prior to September 1998 the ringgit was a widely traded and largely uncontrolledcurrency. Exchange controls were reimposed as a political and economic response to ‘speculation’ in the ringgit depressing its value.The implications of exchange controls on an economy are far-reaching, and beyond the scope of this book.
64
Currency Overlay
Box 4.2
Currency unions
Currency unions are the adoption of one currency by more than one sovereign country. Theyhave a long and somewhat chequered history, the most successful being unions betweencountries at least one of which was not fully sovereign. In the last 200 years – a periodsufﬁciently recent to have some meaningful parallels with the current unions – there havebeen several currency unions, all of which have failed.The Latin Union of 1865 was an attempt by France to create a common currency inthe ‘Latin’ trade area (France, Italy, Switzerland, Belgium, Greece). It faded after the FirstWorld War, and was formally abandoned in 1927. Sweden, Denmark and Norway formed asimilar union in 1870, and this also failed after the First World War. The US, with its strongfederal bias, did not establish a federal currency until 1863, in the middle of the Civil War,when there was arguably not a single state. The dollar has endured – a reﬂection perhapsof the overarching power of the federal government over individual states of the US.A feature of all these unions, however, is that they came at a time when the gold standardheld sway. The gold standard, in a way a global Exchange Rate Mechanism, was themechanism by which governments guaranteed the convertibility of their paper currency (i.e.bank promises) into an incorruptible and absolute commodity – gold. The gold standardhad one fundamental feature which rendered it unsuitable for the currency platform afterthe ﬁrst half of the twentieth century – it was inﬂexible. It did not allow individual countriessuffering different economic conditions from their economic partners to alter domesticmonetary conditions or devalue or revalue their currencies. See also Section 4.1.5.
4.1.5 The euroUntil the end of 1998, most EU member states tied their currencies more or less looselytogether in the ERM (Exchange Rate Mechanism), an exchange rate system that had beenin force in one form or another for over 20 years. The ERM was an anomaly in the generaldevelopment of the FX market because it clearly represented a throwback, in concept if notin execution, to the old controlled-rate parities in Bretton Woods. It had suffered badly fromsuccessful market pressure for realignments; twice in serious attacks, 1992 and 1993, and onseveral lesser occasions (mainly involving the French franc/Deutschmark parity) in the 1980sand 1990s.The ERM was replaced in January 1999 by the euro, a new currency which replaced 11currencies4 in the EU in an unprecedented experiment in monetary union. Whatever the meritsor otherwise of such a major and untested step in monetary arrangements between states, theeffect on the FX markets was to eliminate the last vestiges of the Bretton Woods legacy, andto create a new, fully liquid and uncontrolled free market in a large new currency. By thetime of writing (2002), the euro has emerged as the uncontested ‘second’ currency behindthe US dollar, and despite some ‘unexpected’ and persistent weakness in the four years sinceit was created, the introduction of the euro into the wholesale markets has been a technicalsuccess.4
Now 12 – Greece joined in January 2001.
Foreign Exchange Market – History and Structure
65
4.1.6 InstrumentsThe dominant role of the banking sector in the development of the foreign exchange markethas to a large extent determined the development of the instruments available. As we have seenabove, the key instruments in the currency markets are spot and forward contracts; bilateralinstruments which are designed to facilitate the management of cross-border transfers of cash.These instruments remain the backbone of the currency market, despite the fact that the majorityof the users of the forward foreign exchange market are using these instruments to hedgecurrency exposure, not to plan ahead the exchange rates at which they are actually going toexchange cash.New types of instruments have only been introduced in the past 15 years. Currency futures arethe largest volume of these new instruments – and the design of currency futures is explicitlyto hedge currency risk, not to facilitate its transfer. Currency futures, as we have seen, aredependent on the massive volume and liquidity of the interbank market for their pricing, andwhile nominally outside the control of the banking sector, have nevertheless been annexed toa signiﬁcant extent by the futures broking arm of major banks.The other signiﬁcant new instruments are currency options. These are more a class thana single instrument, since the nature of the instrument allows almost inﬁnite diversity. Theyare heavily promoted by banks, particularly in their less plain vanilla forms, as they represent an opportunity for more opaque pricing, and therefore more proﬁt potential, than the‘commoditised’ spot and forward markets.
4.2 BASIC STRUCTUREThe foreign exchange (FX) market is by far the largest market in the world, with unparalleledliquidity and natural two-way trading. Information ﬂows almost instantaneously through themarket, and there are no insider trading laws and no common taxation regime to distort marketclearing prices. There is no brokerage commission on wholesale trading, and the only formof payment to banks for market-making is the difference between their quoted buying andselling prices – so-called ‘bid/offer’ spreads. The number of participants in the market ishuge – measured in hundreds of millions if direct and indirect players are included. All theingredients, one would imagine, for an efﬁcient5 market if ever there was one. Figure 4.1illustrates the core structure.The diagram has been pared down to avoid confusion – in practice FX customers are highlyvaried, and very numerous. They will typically have dealing arrangements with a number ofbanks. The banks shown in this diagram are market-making banks – this is explained in detailbelow – and they communicate with each other to ‘clear’ the balance of positions they cannoteliminate through customer orders through the interbank network.Although the network is shown as a concrete entity, in reality the network is a series ofbilateral relationships between the market-making banks – their communication is generallyby screen-price and telephone. The CLS Bank (see Box 4.5) is not included in this diagram(and would not be even when it is up and running), because it has no role in the price-settingand position-clearing process.5Efﬁcient in the academic sense of the word. This is to be distinguished from execution efﬁciency, in which the currency marketis the unchallenged world leader. Efﬁciency