<s> Currency Strategy
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Currency StrategyThe Practitioner’s Guide to Currency Investing,Hedging and ForecastingSecond Edition
Callum Henderson
C 2006Copyright 
Callum Henderson
Published by
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,West Sussex PO19 8SQ, EnglandTelephone
(+44) 1243 779777
Email (for orders and customer service enquiries): cs-books@wiley.co.ukVisit our Home Page on www.wiley.comAll Rights Reserved. No part of this publication may be reproduced, stored in a retrieval systemor 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 1988or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 TottenhamCourt 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 emailedto permreq@wiley.co.uk, or faxed to (+44) 1243 770620.Designations used by companies to distinguish their products are often claimed as trademarks. All brandnames and product names used in this book are trade names, service marks, trademarks or registeredtrademarks of their respective owners. The Publisher is not associated with any product or vendormentioned in this book.This publication is designed to provide accurate and authoritative information in regard tothe subject matter covered. It is sold on the understanding that the Publisher is not engagedin rendering professional services. If professional advice or other expert assistance isrequired, the services of a competent professional should be sought.Other Wiley Editorial OfficesJohn Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USAJossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USAWiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, GermanyJohn Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, AustraliaJohn Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1Wiley also publishes its books in a variety of electronic formats. Some content that appearsin print may not be available in electronic books.Library of Congress Cataloging-in-Publication DataHenderson, Callum.Currency strategy : the practitioner’s guide to currency investing,hedging and forecasting / Callum Henderson. – 2nd ed.p. cm.ISBN-13: 978-0-470-02759-2ISBN-10: 0-470-02759-21. Foreign exchange. 2. Hedging (Finance) 3. Speculation. I. Title.HG3851.H464 2006332.4 5–dc222006005368A catalogue record for this book is available from the British LibraryISBN 13 978-0-470-02759-2 (HB)ISBN 10 0-470-02759-2 (HB)Typeset in 10/12pt Times by TechBooks, New Delhi, IndiaPrinted and bound in Great Britain by Antony Rowe Ltd, Chippenham, WiltshireThis book is printed on acid-free paper responsibly manufactured from sustainable forestryin which at least two trees are planted for each one used for paper production.
ContentsPreface to the Second Edition
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Acknowledgements
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About the Author
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Introduction
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PART ONE THEORY AND PRACTICE
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1 Fundamental Analysis: The Strengths and Weaknessesof Traditional Exchange Rate Models1.1 Purchasing Power Parity1.1.1 Reasons for “Misalignments”1.1.2 Tradable and Non-Tradable Goods1.1.3 PPP and Corporate Pricing StrategyExample 1Example 21.1.4 PPP and the Real Exchange Rate1.2 The Monetary Approach1.2.1 Mundell–Fleming1.2.2 Theory vs. Practice1.2.3 A Multi-Polar rather than a Bi-Polar Investment World1.2.4 Two Legs but not Three1.2.5 Implications for New EU Member States1.3 The Interest Rate Approach1.3.1 Real Interest Rate Differentials and Exchange Rates1.4 The Balance of Payments Approach1.4.1 A Fixed Exchange Rate Regime1.4.2 A Floating Exchange Rate Regime1.4.3 The External Balance and the Real Exchange Rate1.4.4 REER and FEER1.4.5 Terms of Trade1.4.6 Productivity
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1.51.6
The Portfolio Balance ApproachExampleSummary
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2 Currency Economics: A More Focused Framework2.1 Currencies are Different2.1.1 (In)Efficient Markets2.1.2 Speculation and Exchange Rates: Cause, Effect and the CycleExample2.1.3 Risk Appetite Indicators and Exchange Rates2.2 Currency Economics2.2.1 The Standard Accounting Identity for Economic AdjustmentExample 1Example 22.2.2 The J-CurveExample2.2.3 The Real Effective Exchange Rate2.3 Summary
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3 Flow: Tracking the Animal Spirits3.1 Some Examples of Flow Models3.1.1 Short-Term Flow Models3.1.2 Medium-Term Flow Models3.1.3 Option Flow/Sentiment Models3.2 Speculative and Non-Speculative Flows3.3 Summary
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4 Technical Analysis: The Art of Charting4.1 Origins and Basic Concepts4.2 The Challenge of Technical Analysis4.3 The Art of Charting4.3.1 Currency Order Dynamics and Technical Levels4.3.2 The Study of Trends4.3.3 Psychological Levels4.4 Schools of (Technical) Thought4.5 Technical Analysis and Currency Market Practitioners
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PART TWO
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REGIMES AND CRISES
5 Exchange Rate Regimes: Fixed or Floating?5.1 An Emerging World5.2 A Brief History of Emerging Market Exchange Rates5.2.1 The Rise of Capital Flows5.2.2 Openness to Trade5.3 Fixed and Pegged Exchange Rate Regimes5.3.1 The Currency Board5.3.2 Fear and Floating5.3.3 The Monetary Anchor of Credibility
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Exchange Rate Regime Sustainability – A Bi-Polar World?The Realworld Relevance of the Exchange Rate RegimeSummary
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6 Model Analysis: Can Currency Crises be Predicted?6.1 A Model for Pegged Exchange Rates6.1.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation6.1.2 Phase II: The Irresistible Force and the Moveable Object6.1.3 Phase III: The Liquidity Rally6.1.4 Phase IV: The Economy Hits Bottom6.1.5 Phase V: The Fundamental Rally6.2 A Model for Freely Floating Exchange Rates6.2.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation6.2.2 Phase II: Speculators Join the Crowd – The Local CurrencyContinues to Rally6.2.3 Phase III: Fundamental Deterioration – The Local CurrencyBecomes Volatile6.2.4 Phase IV: Speculative Flow Reverses – The Local CurrencyCollapses6.3 Summary
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PART THREE
THE REAL WORLD OF THE CURRENCYMARKET PRACTITIONER
7 Managing Currency Risk I – The Corporation: Advanced Approaches toCorporate Treasury FX Strategy7.1 Currency Risk7.2 Types of Currency Risk7.2.1 Transaction Risk7.2.2 Translation RiskExample7.2.3 Economic Risk7.3 Managing Currency Risk7.4 Measuring Currency Risk – VaR and Beyond7.5 Core Principles for Managing Currency Risk7.6 Hedging – Management Reluctance and Internal Methods7.7 Key Operational Controls for Treasury7.8 Tools for Managing Currency Risk7.9 Hedging Strategies7.9.1 Hedging Transaction Risk7.9.2 Hedging the Balance SheetExample7.9.3 Hedging Economic Exposure7.10 Optimization7.11 Hedging Emerging Market Currency Risk7.12 Benchmarks for Currency Risk Management7.13 Budget Rates
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7.14 The Corporation and Predicting Exchange Rates7.15 SummaryAdditional Section for the Second Edition
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8 Managing Currency Risk II – The Investor: Currency Exposurewithin the Investment Decision8.1 Investors and Currency Risk8.2 Currency Markets are Different8.3 To Hedge or not to Hedge – That is the Question!8.4 Absolute Returns – Risk Reduction8.4.1 Passive Currency Management8.4.2 Risk ReductionExample8.5 Selecting the Currency Hedging BenchmarkExample8.6 Relative Returns – Adding Alpha8.6.1 Active Currency Management8.6.2 Adding “Alpha”8.6.3 Tracking Error8.7 Examples of Active Currency Management Strategies8.7.1 Differential Forward Strategy8.7.2 Trend-Following StrategyExample8.7.3 Optimization of the Carry Trade8.8 Emerging Markets and Currency Hedging8.9 SummaryReferencesAdditional Section for the Second Edition
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9 Managing Currency Risk III – The Speculator: Myths, Realities and Howto be a Better Currency Speculator9.1 The Speculator – From Benign to Malign9.2 Size Matters9.3 Myths and Realities9.4 The Speculators – Who they are9.4.1 Interbank Dealers9.4.2 Proprietary Dealers9.4.3 “Hedge” Funds9.4.4 Corporate Treasurers9.4.5 Currency Overlay9.5 The Speculators – Why They Do It9.6 The Speculators – What They Do9.6.1 Macro9.6.2 Momentum (and Fellow Travellers)9.6.3 Flow9.6.4 Technical9.7 Currency Speculation – A Guide
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9.8 SummaryAdditional Section for the Second Edition
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10 Applying the Framework10.1 Currency Economics10.2 Flow Analysis10.3 Technical Analysis10.4 Long-Term Valuation10.5 The Signal Grid10.6 Risk Appetite Indicators10.7 Exchange Rate Regimes10.8 Currency Crises and Models10.8.1 CEMC10.8.2 The Speculative Cycle10.9 Managing Currency Risk I – The Corporation10.9.1 Types of Currency Risk10.9.2 Internal Hedging10.9.3 Key Operational Controls for Treasury10.9.4 Optimization10.9.5 Budget Rates10.10 Managing Currency Risk II – The Investor10.10.1 Absolute Returns: Risk Reduction10.10.2 Selecting the Currency Hedging Benchmark10.10.3 Relative Returns: Adding Alpha10.10.4 Tracking Error10.10.5 Differential Forward Strategy10.10.6 Trend-Following Strategy10.10.7 Optimization of the Carry Trade10.11 Managing Currency Risk III – The Speculator10.12 Currency Strategy for Currency Market Practitioners10.12.1 Currency TradingExample10.12.2 Currency HedgingExample10.13 Summary
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11 Emerging World: New Growth Markets for Global FX11.1 The Growth of Emerging Markets as an Asset Class11.2 Increasing Importance of EM Currencies11.3 Explosive Growth in Asian Currencies11.4 Asian NDF Markets: Growth and Liberalization11.5 Emerging European Currencies11.6 Latin American Currencies11.7 Summary
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Conclusion
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Index
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Preface to the Second EditionSome two years have passed since the first edition of Currency Strategy was published. In thattime, the global currency or “FX” market – already the biggest and most important financialmarket in the world – has grown substantially, both in terms of breadth and depth. Forecasterswho had anticipated the demise or at least the decline of the FX market due to challengessuch as the Euro and technological innovation have been proved utterly wrong. The FX markethas adapted more than successfully to these new challenges and in so doing new investorclasses have been created, which seek to harness its power. Currency overlay investors, whohave currency hedging benchmarks and seek to manage currency returns separate from theunderlying, were certainly around well before 2002. However, the currency overlay industryhas to a significant extent come into its own these last few years and is now confirmed as aseparate and specific investor base. Similarly, central banks are now seen as an investor basein their own right. This is a significant change from previous times when they managed theirown portfolios purely or largely for liquidity purposes and were rarely seen in the market, andin those few cases for the purpose of intervening against the market. Now, they have becomepart of the market itself. The FX market has finally been recognized for what it is, a separateasset class to fixed income and equity, whose risks have accordingly to be managed separately.How easy it is to forget now the predictions of earlier years and moreover the attempts bygovernments and central banks to control or even eliminate the FX market. For a time, it didindeed appear as if the FX market was declining, both in size and use. The Bank of InternationalSettlements’ (BIS) tri-annual survey of 2001 showed a 20% fall in global daily FX turnover toaround USD1.2 trillion from USD1.5 trillion in 1998. The advent of the Euro had eliminated 11currencies and with it the need to manage currency risk within an economic trade zone roughlythe size of the US economy. The prospect of 10 more countries joining the European Unionin 2004 and thereafter into the Euro itself would surely further reduce the need for managingcurrency risk. Japan had called for an Asian version of the International Monetary Fund to becreated and public suggestions were made about a possible Asian trade union to be created atsome point, followed by a possible currency union. Some Latin American nations adopted theUS dollar and there was even a suggestion that Canada should de facto become the 51st stateby itself adopting the US dollar. The UK was under increasing pressure to bow to Euro-zonedemands to set a timetable for adoption of the Euro, which if implemented would needless tosay put such countries as Sweden, Denmark, Norway and Switzerland under pressure to dolikewise. The process of currency elimination, and therefore of the need to manage currencyrisk, seemed at one stage to be almost irreversible.
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That is now hard to believe indeed. As the 2004 BIS survey confirmed, the global FXmarket has bounced back with a vengeance, proof not that it is necessarily the best systembut that, like democracy, it is better than most of the rest. Global FX daily turnover as ofthe 2004 survey was a record high of USD1.9 trillion, a near 60% increase on 2001. It hasbecome the conventional wisdom that currency is a separate asset class that has to be managedseparately from “underlying” equity or fixed income. Moreover, currency managers are nolonger regarded as “speculators” but as investment managers in their own right. Simply put,currency is a risk and it has to be managed. However, if it is a separate risk to be managed, thenone needs a separate and distinct analytical framework with which to analyse and manage thisrisk.This is one of the three main themes of Currency Strategy. As readers may no doubt beaware, there is a rich literature on the subject of “FX” or exchange rates. However, muchof this is academic, with little apparent practical application. Moreover, there were – andremain – few books aimed at currency market practitioners themselves. Currency Strategysought to fill that gap, firstly by looking at the traditional exchange rate models – much-lovedby academia but seen as practically irrelevant by traders – examining their shortcomings, andtrying to suggest modest, but important improvements, that might make them more practicalto the end user. As currency is a separate asset class, it needs a separate analytical framework.This I termed “currency economics”, which seeks not only to focus on the currency-relatedaspects of classical economic theory, but also to marry these with recent innovations in flow,technical and behavioural finance analysis.Developing a separate analytical framework to manage currency risk is a good starting point,but left there this is clearly not enough. The second theme therefore is that currency marketpractitioners need to adopt a rigorous and disciplined approach to managing currency risk orcurrency strategy. This represents their overall framework for managing currency risk. Withinthis, they should decide not only their analytical parameters for managing currency risk, butalso their practical parameters. Within this second theme, currency analysis goes from beingtheoretical to practical – from “it’s going up” to “buy now!”.A third theme, however, is that currency market practitioners need to be broken down intospecific types. Having an overall strategy for managing currency risk is excellent, but this maynot necessarily reflect the specific nature of the risk you are managing. The approach thathedge funds have to managing currency risk is – or at least should be! – completely differentfrom that of, say, a corporate treasury. Here too, currency strategy is the starting point. Fromthere, we need to drill down to the specific type of currency market practitioners in order tomanage their specific risks appropriately.As such, Currency Strategy is all about theory, strategy and execution. Ultimately, my aimin writing the book was to fill what I perceived to be a gap in the available literature on theglobal FX market, preferably in a user-friendly manner for currency market practitioners, andultimately to provide a more appropriate framework for analysing and managing their specificcurrency risks. Writing on any subject is, as ever, somewhat of a trial balloon; you hope whatyou have to say is interesting and worth reading, but you never know for sure until the bookleaves the shelves.It is very gratifying to me therefore that, although the original may have contained manyflaws and omissions, the very fact that I am writing this Preface to the Second Edition confirmsthat the book struck a chord with its intended audience. As ever, I am most grateful to you, thereader, for taking your time – and spending your hard-earned money – to read this work. Likethe economic law of demand and supply, without you, this would have never been written.
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In this second edition I have included several additional sections, including the following:
r A Preface to the Second Edition.r Important additions to Chapters 7, 8 and 9, which form the backbone of Part Three: TheReal World of the Currency Market Practitioner, and deal respectively with corporations,“real money” and speculators.r A new chapter – Chapter 11 – which focuses on the latest developments in the emergingmarkets, particularly in Asia, and how these new markets may impact the global FX market.The purpose of this Preface is to put the book within the context of global FX market developments since the book was first published. As noted above, the book sought to fill a gap –and for the most part succeeded, given the response. That need remains – hence the reason forthis second edition. In Part Three of the first edition I sought to examine in detail what I callthe Real World of the Currency Market Practitioner. Theory is fine, but it is practice andexecution that differentiates one from another. Part Three is the backbone of the book – whatmakes it succeed or fail. Here, in this second edition, I have made important new additionsto Chapter 7, 8 and 9, dealing respectively with the worlds of corporations, real money andspeculators. For the sake of clarity, these are in the form of Additional Sections at the endof each chapter after the Summary, examining the latest developments and techniques in themanaging of currency risk for corporate treasury, portfolio managers, traders and hedge funds.Chapter 7 is the first of three chapters on Managing Currency Risk, focusing on howcorporate treasury manages currency risk. The basic building blocks for a corporation tomanage currency risk are to identify transaction risk, translation risk and economic risk. Fromthis, and using a “budget” exchange rate, the corporation can devise an overall hedging policyfor managing all its main currency risks. However, how a corporation manages these risks isleft open to the corporation, depending on their overall hedging policy. It was a key conclusionof the first edition that corporations should base their transaction hedges on their fundamentalexchange rate forecasts. They take a view and then they hedge – or not – accordingly. This is verymuch a linear approach to managing risk. However, there have been important developmentsin the managing of currency risk by investors, notably regarding the concept of risk appetite,which could undoubtedly help corporations to manage their own risk. Indeed, such an approachmay help both with regard to timing and direction. In addition, corporations also deal with oneoff event risks such as what has been called “bid-to-award” risk, which involves the question ofhow to hedge a bid for a specific project. We also look at this concept in the revised Chapter 7.Chapter 8 is the second of the three chapters on Managing Currency Risk, focusing on howasset managers and currency overlay managers manage currency risk. In it, we looked at thereasons for managing currency risk on either an active or passive basis, the use of currencyhedging benchmarks and various examples of active currency management strategies. In thisedition we take a look at the recent advances made by the Currency Overlay investor class andthe very latest strategies that are being adopted. In particular, there has been a marked increase inquantitative strategies to accompany if not quite replace macro discretionary strategies. Thesehave mirrored to some extent the rise of the systematic trading model community, which wewill look at in more detail in Chapter 9.Chapter 9 is the third and final chapter on Managing Currency Risk, focusing on so-calledcurrency “speculators”. There are many ways to define a “speculator”. For this purpose, we doso purely on an amoral base, focusing on active currency management in the complete absenceof any other underlying or attached asset market. In this chapter, we sought to take a detailedlook at the world of currency speculators, including interbank dealers, proprietary dealers,
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hedge funds, corporate treasury – yes, them too – and currency overlay. There are howeverother types of currency speculators. We took an initial look at the world of momentum traders.Here, in the second edition, we do so in more detail, examining the rise of the systematic tradingmodel community, which, to be sure, did not just focus on currencies, but has certainly becomean increasingly important factor in determining price action within the global FX market as awhole. Because many trading models tend to use similar systems, they tend to turn or “flip”at the same time. Thus, they exacerbate both trend breaks and trend extensions. Either way,they have added to market volatility – something that other market participants in the globalFX market ignore at their cost.Finally, I have added a Chapter 11, entitled Emerging World: New Growth Marketsfor Global FX, looking at the increasing importance of emerging markets to the global FXmarkets, particularly those of Asia. The global economy has undergone profound change sincethe collapse of the Soviet Union and the removal of the Berlin Wall. The markets of what usedto be called Eastern Europe have been opened up. Asia has undergone a profound experimentin market liberalization, albeit one that received a temporary if violent setback in 1997 – 1998.Brazil, previously seen as “the country of the future – and it always will be” has benefiteddramatically since 2002 from a new administration that has been favourably disposed towardsreal and significant economic reforms. The thought that Brazil might at some stage becomeinvestment grade, previously seen as unthinkable or even laughable, is now widely sharedwithin the emerging market investor community. So-called Emerging Market economies havegrown significantly in terms of their global importance. This is particularly true in the caseof Asia. Japan has for long been the second largest and most important economy after theUnited States. To this has now been added China. For now, it is clearly the third largesteconomy in the world, but at current growth rates it will soon displace Japan in second placeand if it keeps growing at its current pace, may even, at some time over the next 20 years,displace the United Sates itself. India has started to open up in a meaningful way. As a result,both fund managers and corporate investors have taken notice and appear to be undergoinga secular change in the way they look at Indian economic prospects. If the current economicliberalization programme remains on track, and if politics is not allowed to interfere, India maywell become one of the largest economies in Asia. South Korea, for its part, is not standingstill. It too is responding to the regional change that is being seen across Asia.The importance of Emerging Markets, and particularly of Asia, is increasingly evident.Asian economies have grown rapidly in recent years. Their balance of payments has improveddramatically and with it FX reserves have exploded. Asian central banks now control over 75%of global reserves, making them potentially the world’s largest currency managers. The conceptof “Bretton Woods II” was not around when the first edition of this book was published, but fornow has become the conventional wisdom that Asian central banks can and will indefinitelyrecycle trade and current account surpluses back to the US, thus effectively keeping theircurrencies pegged to the US dollar. We take a detailed look at the increasing importance of“emerging Asia” within both the global economy and the global FX market and examinewhether or not this Bretton Woods II mechanism as it has been described is sustainable.Whether or not that is the case, the emphasis within the global FX market is clearly shiftingtowards the emerging markets and in particular to Asia, given its increasing importance to theglobal economy. This appears to be trend that may last for decades rather than just years.Africa is also showing potential. Once thought of as a “basket case”, it remains the one lastuntapped continent. There is much to be optimistic about. The number of wars fought on theAfrican continent has fallen sharply and governments are focused on economic revitalization
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programmes. In addition, the HIPC programme of debt relief will for many give the opportunityof a fresh start. The scourge of AIDS, persistent conflicts in specific cases and finally direpoverty remain significant challenges. Nevertheless, the opportunity is enormous. South Africais an excellent example of what can be achieved as a result of prudent economic management.Growth is consistently strong. Inflation-fighting credibility has resulted in the lowest inflationrate in decades. It will take years for African economies and markets to open up fully, but thepotential for active FX markets across the continent is significant.Just as active and passive currency management, both from a corporate and an investorperspective, has become a dominating focus across the developed markets, so it will spreadacross the Emerging Markets as domestic markets open up. The global FX market will continueto grow and with it the need to manage currency risk across these markets as a separate anddistinct asset class.
AcknowledgementsAs with the first edition of this book, I am greatly indebted to Rachael Wilkie, Chris Swain andeveryone else involved from John Wiley & Sons for the initial invitation to write on this topicand subsequently for their advice, encouragement and diligent editorial work. It is a pleasureto work with people as professional as these.My deepest gratitude goes to my wife Tamara, for her patience, love and understandingduring both editions of the book. I am also as ever indebted to my father and to the memory ofmy mother, who battled to get me to read at an early age, an effort that successfully unleashedan avalanche of reading, enquiry and travel. What little or otherwise I have become is down totheir 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 offinancial markets is a reflection both of their experience and of their interaction with marketparticipants. Theory is fine but there is nothing like watching and listening how it is done atthe sharp end. In my career, I have been fortunate enough to come across a broad spectrumof experts in their respective fields, in central banks, in dealing rooms and within governmentand international organizations. They in turn have been kind enough to give of their time andtheir views. Space, consistency and in some cases the respected need for anonymity requirethat these do not be named individually. Suffice to say they know who they are and it is mypleasure and privilege to have met them.Last but not least, I wish to thank the readers. Having served in many capacities in my career,in journalism, in business, in analysis and finally in banking, an abiding theme of mine hasbeen to keep a clear focus on the most important people in whatever field one is in – the client.Too many forget this most fundamental rule of commerce. Thus, in this small way, I thank thereaders for taking their time to examine the ideas I have presented here and trust that in somemeasurable way they feel they have benefited