��exibility left to the major participants (who are long) is to sell. Thisforms the basis for the argument to do the opposite to the ‘herd’. There are very few situationsin the currency market when the ‘herd’ is clearly identiﬁable, and even then usually with thebeneﬁt of hindsight. Herds require an element of community and common values/language andculture. These do not exist to any extent in the FX markets. There are many herds, and they allsee the world differently. Momentum managers are more overtly technical, but underpinningtheir approach is to go with the prevailing price trend, and therefore implicitly with the herd.This makes their behaviour mirror the technical trend-follower.Both of these styles resonate to ‘what everyone else is doing’, and so concern themselveswith game theory as well as just price movements. The game theory element is less evident inthe currency markets than in smaller markets because of the diversity of players, their variedmotivations and the opacity of their activities.13.1.4 EthicalEthical managers probably do not have a counterpart in currency management. The onlyparallel that could be drawn is the possible future emergence of a repugnant regime in thecurrent members of the global FX market – currently less than 20 countries. However, oneof the characteristics of repugnant regimes is that they tend to deprive their population offreedoms. The continuance of a freely tradeable exchange rate in dictatorial conditions istherefore unlikely, and similarly the emergence of the currency of a repugnant regime into theglobal market is equally unlikely.
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13.1.5 Hedge fund stylesMost of the style categories are inappropriate for currency overlay managers. The only substantive style which has incorporated active currency management is the global macro style. Twoevents stand out in which hedge funds of this style entered the currency market in a substantial(and price-changing) way.The ﬁrst is the celebrated case of George Soros and the pound sterling in September 1992.This was, in effect, an event-driven opportunity in which George Soros used the assets ofhis main hedge fund vehicle, the Quantum Fund, to speculate against the self-imposed lowerlimit of the pound versus the DEM in the (now defunct) European Exchange Rate Mechanism(ERM). It appears that Soros took a leveraged position of about £10bn against the pound,and this was one of the straws that broke the camel’s back – the UK government capitulating to the market pressure, and (permanent) withdrawal from the ERM. This was a highlypublicised win for George Soros, who was rumoured to have made £1–2bn in the QuantumFund.The second entry of hedge funds into the currency market was less happy. This is the periodin 1998 when a group of hedge funds ‘spotted’ what they regarded as an opportunity to take ashort position against an already weak yen, and be ‘paid’ for it – the yen ‘carry’ trade. Theywere ‘paid’ to do this by the interest rate differential between the yen and the USD – yen couldbe ‘borrowed’ much cheaper than USD could be deposited. The ‘opportunity’ turned out tobe a chimera – in two days on 7/8 October 1998 the yen appreciated by about 12%, and thecurrency market showed real disarray (it was almost a one-way market) – a truly rare event.The trigger for this startling movement was the risk-control processes of the hedge funds tryingto close out their rapidly worsening positions all at the same time and in the same direction.Hedge funds collectively lost a great deal of money, and perhaps even more conﬁdence in thisdebacle. Currency overlay managers were not totally unscathed, but the diversiﬁed nature oftheir portfolios and their diversiﬁed styles saved them any serious embarrassment.There are other examples of event-driven ‘opportunities’ being spotted by hedge funds, butmany of the lesser known were thoroughly unsuccessful. One of the most important is a seriesof unsuccessful attacks on the 7.80 HK dollar parity with USD – and the adverse interest ratedifferential was serious punishment for the lack of success.Will this style enter the currency overlay style universe? I believe that the answer is probablynot. Currency overlay’s attraction is its ability to provide more predictable and stable results,from established processes, rather than speculative opportunities with undiversiﬁed risks.
13.1.6 Summary on stylesNone of the existing style descriptors of equity or hedge fund managers ﬁt the needs of currencyoverlay clients particularly well. Nor do they play to currency overlay managers’ strengths.My own instinct is that technical, fundamental and dynamic hedging styles will (continue to)lose their very distinct characters, and that managers with become less differentiated by thesecriteria. I believe that all these managers are already exploiting the same inefﬁciencies, andindeed many of the processes of an overtly fundamental manager may match those of an overtlytechnical manager.The distinction that I think will become increasingly drawn is, on the one hand, managerswho rely on the full rigour of models and processes; and on the other hand, discretionary‘expert’ managers who are guided by models and indicators, but who take individual decisions
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on the basis of their judgement. We could call these systematic and discretionary. As withall styles, there will be gradations in between the poles, but the meaning is quite clear. Somecommentators, and managers, already use one or both of these descriptions to categorisemanagers. I think this trend will continue.
13.2 NATURAL SELECTION OF OVERLAY MANAGERSAccording to Mercer, the investment consultant, the ﬁrst stand-alone currency overlay mandatewas signed in April 1985. Prior to this, several (probably around three or four) of the currentuniverse of managers (or their principals) had activities in active currency management. However, none of the contracts under which these activities were undertaken were identiﬁablycurrency overlay. By the late 1980s, there were still comparatively few managers offering currency overlay (perhaps six or seven), and there were very few currency overlay mandates. Theearly 1990s saw rapid growth in the number and scale of overlay mandates, particularly fromUS pension funds (and some endowments). This encouraged the formation of new overlaymanagers to service (and stimulate) this demand, and the manager universe grew substantially. A number of the new managers were formed as independent ﬁrms by principals whomainly came from investment banks rather than investment managers. Some developed out ofa ‘currency desk’ in existing (larger) investment managers. By the late 1990s, the number ofmanagers with $1bn or more under management was probably in the teens.There was a slow-down in the growth of overlay from US institutions after the mid-1990s,but other investing countries, notably Australia, the Netherlands, Switzerland and latterly theUK have continued to create new overlay mandates as their international allocations have risen,and the currency risk has been recognised and dealt with. The currency overlay universe now(in early 2003) probably numbers 40 managers. Many are quite small, and many are also newto overlay. As with all active management populations, there has already been a certain amountof culling of managers, and this will continue. The managers who have been proven most ableto survive so far have been those with a well-differentiated style and strong ‘brand’, and thosewith backing from a large international asset manager, investment bank or custodian. The mostvulnerable are the newest, who lack a stand-alone track record, and those with a scale toolimited to weather difﬁcult trading conditions.Fees in active currency management are low by the standards of other active managementclasses. Active currency overlay fees are likely to be in the range 5–50 bp p.a., depending onthe scale and complexity of the account. Most active overlay managers will average around10–15 bp. If we round this to 12 bp, then this is $1.2m in annual fees per $1bn of overlay.Passive mandates would attract fees of 1–10 bp, with most managers averaging passive feesof 2–3 bp for large mandates, although signiﬁcantly higher for small mandates.There is no evidence that there is any serious upward pressure on fees, particularly indepressed asset return environments. Likewise, the fee levels are probably sufﬁciently lowthat there is unlikely to be downward pressure from aggressive pricing from new or growthorientated participants.Table 13.1 gives some very rough guesstimates of the currency overlay market at end-2002(it is based on international assets shown in Table 2.2). The penetration percentages are my(rounded) estimates; this produces spuriously accurate estimates of overlay mandates in $bn.The accuracy is spurious, and should therefore not be relied on. Most of these mandates willbe active overlay, the mix is probably 80:20 active:passive at the time of writing.
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Table 13.1 Overlay geographical penetration analysisCountryUSUKSwitzerlandNetherlandsJapanCanadaSwedenAustraliaHong KongGermanyBelgium/FranceTotal
International assets(US$bn)
% Penetration
Overlay mandates(US$bn)
569291119100643329238981251
9%3%5%10%3%3%2%55%6%6%13%7%
51.28.76.010.01.91.00.612.40.50.51.093.7
Source: Record Currency Management Estimates, December 2002.
From this information, we can calculate a very rough approximation of the fee revenuesavailable to the currency overlay manager universe:Assets × Average fee rate = Annual income= $94bn × [(0.8 × 12 bp) + (0.2 × 3 bp)]= $96mThis means that 40 ﬁrms are sharing revenues of $96m, or around $2.5m each if it was equallyspread (which it is not). $2.5m is probably below the critical fee income level required tosupport the research, product development, systems and compliance costs at the minimumlevel necessary to be a viable manager. This implies that one or more of three things are likelyto happen: consolidation of the smaller players into the larger; closure or withdrawal of thesmaller players; or signiﬁcant growth in the overlay market.There is no immediate evidence from the stated intentions of investors that overlay willexperience rapid growth over the next few years. Overlay is likely to continue to increase penetration in existing international allocations, and these may well grow with the continuing trendof internationalisation. Countering this, there is some evidence that international allocationsin the US have peaked, and that the disappointing return experience of many US investors willcap their desire for more international diversiﬁcation.
13.2.1 Conﬂict of interestThere is a ﬁnal point to be made on overlay managers’ income. There are some overlaymanagers that are part of large investment banks. To the extent that mandates permit them todeal with their own dealing desks, this is a source of customer FX turnover, and therefore proﬁt,to the dealing room. One or two FX dealing rooms have established ‘overlay’ teams based inthe dealing rooms, and they are quite explicit about their desire to increase customer turnover.These are not serious overlay managers, and they will always be hugely compromised by theconﬂict of interest and the dealing culture of their employers.
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More difﬁcult to dismiss are bank subsidiary overlay managers who are set up, and operateout of, an investment management arm of the bank. Many of these are serious and successfuloverlay managers; it rests with the client to specify the overlay contract in such a way that theycan be certain that conﬂicts of interest do not arise. My recommendation to any client wouldbe to forbid such a manager from dealing with their associated bank. This (harsh) prescriptionis the only one that can guarantee no conﬂict.
13.3 EXTENDING THE RANGE OF HEDGING INSTRUMENTSThe current range of hedging instruments available to an overlay manager is so liquid, low-costand ﬂexible that it seems churlish to want more or different. From my experience, the onlyserious drawback from the customer’s perception of the current range is the regularity, andsize, of the cash ﬂows associated with the maturity, and rolling, of forward contracts.Innovation in this area may reduce the hurdles for some investors embarking on overlay,and it is possible that currency swap technology holds the key. The scope of this book doesnot allow me the space to explore such designs in any more detail.
13.4 WILL INEFFICIENCIES GROW OR SHRINK?Markets are never static creatures, and the FX market is no exception. For most asset markets, the answer to this question is that current inefﬁciencies will shrink and disappear, andnew inefﬁciencies, currently absent or undreamt of, will appear. The active manager in thesemarkets is therefore like the hunter – equipped to spot, chase and kill the prey wherever itappears.For the FX market, I think the answer is different. The FX market, as I have laboured inthis book, is a leviathan that is the clearing-house for a very large volume of trading that is notdirectly proﬁt-oriented. The secret of how current inefﬁciencies will develop therefore lies inaccurate prediction of how the structure and make-up of the market will change. I see littleshort-term structural change in the market’s customers. The market’s suppliers, the banks, haveundergone radical consolidation over the past 10 years, but this has not markedly changed theclearing or price-setting mechanisms. In the more distant horizon, I see a continuing rise incapital account FX trading (which includes hedge funds and currency overlay managers, andalso conventional asset managers, as well as investment banks on behalf of, for example, M&Aclients). However, the rate of growth is not likely to be high as long as asset markets remaindepressed, and since these sources are a relatively small proportion of the current price-takingcustomer community at the moment, they will remain so in the mid-term.This leaves the door open for existing inefﬁciencies to continue to exist, despite their beingopenly recognised and discussed among the active currency management community. Thestyle of active manager that will thrive in this environment is less like the hunter (responsive,restless, instinctive, action above care) and more like the farmer (planner, order, knowledge,process, care above action). The best farmers are those who possess the properties above, plusan entrepreneurial and intellectually curious streak that leads them to investigate new methodsof production, new processes and new machinery. The best overlay managers will possessthese qualities too.
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13.4.1 Can outperformance by currency overlay managers continue?The short answer is ‘yes’. The inefﬁciencies that currency overlay managers exploit are related to the unique structure of the FX market, not to any particular style or ‘view’ held bycurrent participants. However, most textbooks on ﬁnancial economics will tell you that priceinefﬁciencies are unlikely to be anything more than temporary, since arbitrage will ensure thatany ‘free lunch’ is fully exploited until it goes away. Why is this not true in the FX market?It is not true for all the reasons discussed in previous sections: the arbitrage is risky, itsexistence is not self-evident, it is heavily dependent on specialist FX market expertise, itcompetes with other opportunities for risk capital, and there is a limited amount of longhorizon risk capital in comparison with the huge volume of capital that ﬂows through themarket daily.My prediction is that over, say, the next decade, the apparent value added of the mediancurrency overlay manager may decline, but still remain above zero after costs. This may comeabout more as a result of the size of the currency overlay manager universe increasing, thanby any diminution of the inefﬁciencies in the FX market. The best, and most consistent, ﬁrmswill continue to add signiﬁcant value, but entry of less sophisticated players may dilute thevalue added of the universe. In my view it is unlikely that any increase in the assets undermanagement in the active overlay universe will by itself be sufﬁcient to signiﬁcantly reduceor eliminate the persistent inefﬁciencies in the FX market.
References/Useful ReadingAIMR Benchmarks and Performance Attribution Subcommittee Report, John C. Stannard et al., August1998.AIMR Conference Proceedings, Currency Risk in Investment Portfolios, 1998.Aitchison, J. and Brown, J.A.C., The Log-normal Distribution, Cambridge University Press, 1963.Bernstein, W.J. and Wilkinson, D., ‘Diversiﬁcation, rebalancing, and the geometric mean frontier’,Efﬁcient Frontier (www.efﬁsols.com), January 1998.Black, F. and Scholes, M., ‘The pricing of options and other corporate liabilities’, Journal of PoliticalEconomy 81 (May/June 1973) 637–659.Black, F., ‘Living up to the model’, Risk Magazine, March 1990.Black, F., ‘Universal hedging’, Financial Analysts Journal, July–August 1989.Brigham, E.F. and Houston, J.F., Fundamentals of Financial Management, The Dryden Press, 8th edn,1998.Clowes, M.J., The Money Flood, John Wiley & Sons, 2000.Econometric Methods, Johnston and Dinardo, McGraw-Hill, 4th edn, 1996.Fama, E.F., ‘Market efﬁciency, long-term returns and behavioural ﬁnance’, Journal of FinancialEconomics 49 (1998) 283–306.Fama, E.F., ‘Efﬁcient capital markets’, Journal of Finance 46 (Dec 1991) 1575–1617.Fama, E.F., ‘Random walks in stock market prices’, Financial Analysts Journal, September–October1965.Fitzgerald, M., Financial Options, Euromoney Publications, 1987.Gardner, G.W. and Wuilloud, T., ‘The Regret Syndrome in Currency Risk Management: A Closer Look’,Russell Research Commentaries, August 1994.Gartland, W.J. and Letica, N.C., ‘The basics of interest-rate options’, chapter 59 in Fabozzi, F.J. (ed.),The Handbook of Fixed Income Securities, McGraw-Hill, 5th edn, 1997.Haugen, R.A., Modern Investment Theory, Prentice Hall, 1993.Jorion, P., ‘Mean/variance analysis of currency overlays’, Financial Analysts Journal, May–June 1994.JP Morgan/Reuters, ‘RiskMetricsTM – Technical Document’, 4th edn, 1996.Karnosky and Singer, ‘Global Asset Management and Performance Attribution’, Research Foundationof The Institute of Chartered Financial Analysts, February 1994.MacDonald and Stein (eds), Equilibrium Exchange Rates, Kluwer Academic, 1999.Markowitz, H.M., ‘Portfolio selection’, Journal of Finance 7 (1952) 77–91.McCutcheon, J.J. and Scott, W.F., An Introduction to the Mathematics of Finance, ButterworthHeinemann, 1986.Nesbitt, S.L., ‘Currency hedging rules for plan sponsors’, Financial Analysts Journal, March–April 1991.Perold, A.F. and Schulman, E.C., ‘The free lunch in currency hedging: implications for investment policyand performance standards’, Financial Analysts Journal, May–June 1988.Rogoff, K., ‘The purchasing power parity puzzle’, Journal of Economic Literature 34(2) (1996).Rosenberg, M., Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange RateForecasting, Richard D. Irwin & Co, 1996.
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References
Rosenberg, M., The Deutsche Bank Guide to Exchange Rate Determination, May 2002.Sarno, L. and Taylor, M., ‘Ofﬁcial intervention in the foreign exchange market: is it effective, and if so,how does it work?’, Journal of Economic Literature 34(3) (2001).Sharpe, W., ‘Asset allocation: management style and performance measurement’, Journal of PortfolioManagement, Winter 1992.Siegel, J.J., ‘Risk interest rates and the forward exchange’, Quarterly Journal of Economics 89 (1972)173–175.Taylor, A.M., ‘A Century of Purchasing-Power Parity’, NBER Working Paper No. w8012, November2000.Tobin, J., ‘A proposal for international monetary reform’, Eastern Economic Journal 4 (1978) 153–159.
AppendicesAPPENDIX 1 – BOUNDARY CONDITIONS FOR FORWARDARBITRAGEThe following sets out the maths that applies in each case:Case 1 The ‘no spread’ world – sterling investor replacing a sterling deposit with a hedgeddollar deposit.Case 2 Real markets – sterling investor replacing a sterling deposit with a hedged dollardeposit.Case 3 Real markets – dollar investor replacing a dollar deposit with a hedged sterling deposit.Case 4 Real markets – borrowing one currency to lend the other, the outer bounds of thearbitrage.Case 1 – No spreadsInvest in sterling direct:(1)Invest an amount of sterling£DEP(2)Interest =£DEP × £LIMID/12(3)Total £ value 1 month£DEP[1 + (£LIMID/12)] = £RETInvest via the dollar:(4)Invest£DEP(5)Convert to $ =£DEP × $£MIDSPOT = $DEPwhere $£MIDSPOT is expressed as dollars/sterling:(6)Interest =$DEP × $LIMID/12(7)Total $ value 1 month$DEP[1 + ($LIMID/12)] = $RET(8)Total £ value 1 month$RET/ $£MIDFWDThe arbitrage is perfect where the total £ value 1 month is equal from both investing routes,i.e. (3) = (8), or:(9)£DEP[1 + (£LIMID/12)] = $RET/$£MIDFWDSubstituting from (7):(10)£DEP[1 + (£LIMID/12)] = {$DEP[1 + ($LIMID/12)]}/$£MIDFWDand rearranging to ﬁnd the forward rate ($£MIDFWD):(11)$£MIDFWD = {$DEP[1 + ($LIMID/12)]} / {£DEP[1 + (£LIMID/12)]}Substituting from (5):
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$£MIDFWD = {(£DEP × $£MIDSPOT) × [1 + ($LIMID/12)]}/{£DEP[1 + (£LIMID/12)]}and simplifying:(13)$£MIDFWD = $£MIDSPOT × [1 + ($LIMID/12)] / [1 + (£LIMID/12)]Or in words, the forward rate is equal to the spot times the ratio of 1 + interest rates (the ratiohas the numerator interest rate on top).We can substitute example values as follows:(12)
$£MIDSPOT = 1.5346£LIMID = 4.9688%
$LIMID = 2.0938%
which gives the forward rate as follows:(14)$£MIDFWD = 1.5346 × [1+ (2.0938%/12)]/[1 + (4.9688%/12)]= 1.5346 × (1.001745/1.004141)= 1.53094and therefore the ‘FX swap’ expressed in ‘FX points’ (1 point = 1/10 000th of $1) at mid-pricesis:(15)1.53094 − 1.5346 = −36.6 pointsCase 2 – Sterling investor with spreadsInvest in sterling direct:(1)Invest an amount of sterling£DEP(2)Interest =£DEP × £LIBID/12(3)Total £ value 1 month£DEP[1 + (£LIBID/12)] = £RETInvest via the dollar:(4)Invest£DEP(5)Convert to $ =£DEP × $£RHSSPOT* = $DEPwhere $£RHSSPOT is expressed as dollars/sterling:(6)Interest =$DEP × $LIBID/12(7)Total $ value 1 month$DEP[1 + ($LIBID/12)] = $RET(8)Total £ value 1 month$RET/$£RHSFWD*One further piece of information is needed, and it refers to $£RHSSPOT and $£RHSFWD.The way in which the forward market is priced is by forward FX points, so, for example, theforward discount of the pound in the previous example might be quoted as −37/−36 (i.e.a ‘one point’ spread). This means that for the deal contemplated above, the bank will sellthe customer dollars at the spot rate, and simultaneously buy it back from them for 1-monthmaturity at 36 points better (better to the investor) rate (i.e. lower number). The bank willnot charge a spot spread, because no spot risk is being taken by them. But in this example,the amount that this investor wants to sell forward is larger (by the interest received) than theamount they are buying, so there will be a very small outright forward deal, which will notonly attract a full spot and forward spread, but will be used by the bank as the spot rate offwhich they will price the whole deal (and this will be the right-hand side (RHS)). In a pure FXswap (i.e. the two amounts of dollar being identical), the bank is indifferent to the spot rateused, and might accept LHS, mid or RHS without preference.This is why I have used $£RHSSPOT as the spot conversion rate, whereas normally theinvestor would buy dollars at $£LHSSPOT. From the foregoing, we can deﬁne the forward ratein this case as follows:
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265
Outright forward rate:$£RHSFWD = $£RHSSPOT + ($£RHSSWAP/10 000)where $£RHSSWAP is the RHS swap points expressed in FX points.Using exactly the same algebra as in the previous case, we can derive the forward pricewhich is just ‘no arbitrage’. So mirroring the previous equation (13):(10)$£RHSFWD = $£RHSSPOT × [1 + ($LIBID/12)]/[1 + (£LIBID/12)]We can substitute example values drawn from market data as follows:(9)
$£LHSSPOT = 1.5345$£MIDSPOT = 1.5346$£RHSSPOT = 1.5347
$LIBOR = 2.1250%$LIMID = 2.0938%$LIBID = 2.0625%
£LIBOR = 5.0000%£LIMID = 4.9688%£LIBID = 4.9375%$£RHSFWD = 1.5347 × [1+ (2.0625%/12)] / [1 + (4.9375%/12)]= 1.5347 × (1.001719/1.004115)= 1.53104and therefore swap points:(12)1.53104 − 1.5347 = −36.6 pointswhich is the same value as the mid-price calculation.So, perhaps a little surprisingly, the arbitrage kicks in instantly – if the UK investor is everoffered better than −36.6 points (i.e. a larger number), the US investment route will risklesslymake him more money than an investment in sterling. It is worth noting that the spot bid/offerspread is irrelevant for this arbitrage – even if interest rates are very high, and, say, the amountof the sale of dollars was 10% more than the amount of the purchase.(11)
Case 3 – Dollar investor with spreadsInvest in the dollar direct:(1)Invest an amount of dollars$DEP(2)Interest =$DEP × $LIBID/12(3)Total £ value 1 month$DEP[1 + ($LIBID/12)] = $RETInvest via sterling:(4)Invest$DEP(5)Convert to £ =$DEP/$£LHSSPOT = £DEPwhere $£LHSSPOT is expressed as dollars/sterling:(6)Interest =£DEP × £LIBID/12(7)Total £ value 1 month£DEP[1 + (£LIBID/12)] = £RET(8)Total $ value 1 month£RET × $£LHSFWDThe algebra from here is similar to the previous cases, but we have reversed the direction ofthe foreign exchange transaction, so we divide where previously we multiplied and vice versa:(9)$DEP[1 + ($LIBID/12)] = £RET × $£LHSFWDSubstituting from (7):(10)$DEP[1 + ($LIBID/12)] = £DEP[1 + (£LIBID/12)] × $£LHSFWDand rearranging to ﬁnd the forward rate ($£LHSFWD):(11)$£LHSFWD = {$DEP[1 + ($LIBID/12)]}/{£DEP[1 + (£LIBID/12)]}
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Substituting from (5):(12)$£LHSFWD = {$DEP[1 + ($LIBID/12)]}/ {($DEP / $£LHSSPOT)× [1 + (£LIBID/12)]}Simplifying and rearranging:(13)$£LHSFWD = [1 + ($LIBID/12)] / {(1/ $£LHSSPOT)× [1 + (£LIBID/12)]}(14)$£LHSFWD = $£LHSSPOT × [1 + ($LIBID/12)]/[1 + (£LIBID/12)]Or in words, the forward rate is equal to the spot times the ratio of 1+interest rates (the ratiohas the numerator interest rate on top). This is the same algebra as Cases 1 and 2 – just the LHSand RHS are different. So it does not matter whether the investor who exploits these arbitrageopportunities is dollar-based or sterling-based.Substituting with values above:(15)$£LHSFWD = 1.5345 × [1+ (2.0625%/12)] / [1 + (4.9375%/12)]= 1.5345 × (1.001719 / 1.004115)= 1.53084and therefore swap points:(16)1.53084 − 1.5345 = −36.6 pointswhich is again the same value as