than the reaction of those who do not actually know theanswer to the puzzle of predicting exchange rates, but are afraid to admit it. Indeed, the verysuccess of such analytical disciplines as flow and technical analysis suggests serious flaws,both in the idea of exchange rates obeying a random walk and in the idea of markets beingperfectly efficient. Both capital flow analysis and “charting” have added significantly to theprofession of currency strategy, not least in its ability to deliver results – and herein lies thekey. The arguments against the likes of flow and technical analysis are usually emotionally – orideologically – rather than empirically based. No-one has actually proved that flow or technicalanalysis do not work, and what empirical evidence we have in fact suggests that they do workand frequently on a more consistent basis than traditional exchange rate models.The focus of the currency strategist, and in turn the currency market practitioner, shouldbe purely practical. This is a business and a business has to achieve measurable results. Ifthat business is to succeed, its results have to outperform consistently. While there are noguarantees – and certainly not with regard to exchange rates – adopting an integrated approachto currency analysis, incorporating currency economics, flow analysis, technical analysis andlong-term valuation based on traditional exchange rate models, gives you the best chance ofachieving that out-performance. At the end of the day, currency strategists do not have theluxury of just giving a view. Your “P&L” is measured in terms of your reputation, and thatin turn is a direct function of the performance of your views over time. That is exactly howit should be. For corporate Treasurers or for asset managers or currency speculators, they arenot putting theoretical money on the line. On the very first day I joined my first bank in 1998as the Asian crisis continued to flare, I was asked by the Finance Director of a multinationalcorporation whether they should hedge their exposure to the Hong Kong dollar and wouldthe peg “go”? My answer was equivocal, not because I am the sort to usually give equivocalanswers but rather because there were two questions involved! On the first, I said that the
236
Conclusion
competitive depreciation of Asian currencies against the Hong Kong dollar meant that the riskpremium embedded in Hong Kong dollar forward prices would most likely rise and potentiallysubstantially. On the second, I said that the peg would remain in place because of the solidfoundations of Hong Kong’s currency board system and the determination of the Hong KongMonetary Authority to keep it in place. Nowadays, this might seem like stating the obvious,but at the time there was real fear in the market that Hong Kong’s “peg” might break, as wasthe case for Asian currency pegs during the Asian currency crisis. I mention this exampleneither for the purpose of 20/20 hindsight nor to “look good”. Rather, I have included it toshow the stakes involved. Of course, the Finance Director will have had his own informedview of the risks involved in the corporation’s specific exposure to the Hong Kong dollar. Atthe time, he most likely wanted an outsider’s view, either to confirm or to question his ownview. That outsider’s view of the currency strategist makes a difference to the end result. If itdidn’t, professional currency market practitioners would not waste their valuable time.For both corporations and investors, the exchange rate remains a crucial consideration withinforeign or overseas investment. At some point, when the world has but one currency, this will notbe the case, but until that happy (?) day, it remains so. The techniques used today, not just to givean exchange rate view but more specifically to analyse and hedge a corporation’s balance sheetrisk or for that matter to help a currency overlay manager to add alpha, have grown significantlyin terms of complexity and sophistication in the past few years. Furthermore, what currencyinstruments were only recently deemed as complex within the developed markets are now seenas plain vanilla relative to the increasingly tailored needs of currency market practitioners – andmoreover are increasingly being demanded by local market participants within the emergingmarkets.It was said at the outset and it has to be repeated here that there is no such thing as objectivity,certainly not where human beings are concerned. This book is the result of my knowledge andexperience, for good or ill, and therefore it is naturally skewed in a particular direction. Thatdirection, that bias has stemmed from the view that there has been a gaping hole in the analysisof the currency markets, a hole which this book attempts to fill. More specifically, having longbeen fascinated by the subject of the currency markets, I have wanted to read a book whichwent beyond the traditional exchange rate models, both for the purpose of examining howthe currency market practitioners themselves deal with currency risk and moreover to havethe temerity to suggest to currency market practitioners a more integrated and rigorous wayof doing so. In short, I could not find anything out there that was actually aimed at currencymarket practitioners themselves, so I decided to write such a book myself. This is not to say thebook is complete. Frankly, practically any book that is focused on financial market analysis,however seemingly exhaustive, is likely in practice to be incomplete. Space and time simplydo not allow for all aspects to be covered. Nevertheless, I trust that the Preface, the AdditionalSections and the inclusion of Chapter 11 in the second edition will go quite some way toatone for the omissions of the first edition.To conclude, the “problem” with trying to analyse, forecast, hedge, trade and invest in thecurrency markets is that currencies are affected by so many factors simultaneously – and tocomplicate matters further the importance of those factors may change over time – so it isdifficult to tell the combined impact of the sum of these factors. To date, none of the traditionalexchange rate models have been able to incorporate all of the possible factors that might impactexchange rates to the extent that they are then able to predict exchange rates on a consistentbasis over a short-term time horizon. Given the number of possible factors involved, this ishardly surprising. The changeability of the importance of these factors is a further complication.
Conclusion
237
For instance, in 2001 a key factor affecting exchange rates was foreign direct investment orFDI. Indeed, in 2001 the top three currencies in the world against the US dollar – the Mexicanpeso, Peruvian sol and Polish zloty – were all the recipient of major FDI inflows which offsettheir current account deficits and thus gave them a basic balance surplus. Within the developedmarkets, FDI inflows have played an important though changing role in the performance ofthe US dollar. In 2000, the US was the recipient of huge FDI inflows, which in turn was seenas a major contributing factor for US dollar strength. FDI inflows slowed sharply in 2001,causing the market to anticipate that the US dollar would fall sharply. It did not happen. Whileadmittedly it did not hit new highs against its major counterparts, the US dollar remainedrelatively strong as the shortfall in FDI inflows was made up for by portfolio inflows, which inturn helped finance the current account deficit. The danger in setting rules about how capitalshould flow to countries with the highest nominal or real interest rates was also apparent in2001. In that year, the Federal Reserve cut interest rates 11 times, bringing the Federal funds’target rate down from 6.50% to 1.75%, while the European Central Bank only cut its refinancingrate from 4.50% to 3.25%. In other words, the difference between the Fed funds rate and theECB’s refinancing rate went from +200 to −150 bp. Despite that, the Euro was still unableto rally on a sustained basis. Relative growth patterns, which at times have been a key driverof the Euro–dollar exchange rate, were also not the main answer. In late 2000 and 2001, USindustrial production contracted for the longest consecutive period since July 1932, or theGreat Depression. In the end, the market came to the view that financial markets rewardedaggressive growth-oriented monetary policy, such as that adopted by the Federal Reserve, inthe form of portfolio inflows. All that one can say about this is that such market favouritismhas not always been the case in the past and is unlikely to always be the case going forward.Indeed, in the future, there may well be other factors that surpass this in terms of their impacton the exchange rate.The discipline of trying to analyse and forecast exchange rates continues to require greatflexibility. If any exchange rate model were able to successfully incorporate all major factors toproduce consistently accurate exchange rate forecasts, it would surely be worthy of the NobelPrize for Economics. For now, the best answer for currency market practitioners remains toadopt an integrated approach to currency analysis and strategy, involving the four disciplinesof currency economics, flow analysis, technical analysis and long-term valuation based on thetraditional exchange rate models.Finally, it should not be forgotten that, despite the increase in global trade flows and theeven greater increase in portfolio capital flows over the last two decades, the currency marketis essentially speculative in nature, that is to say a majority of currency market practitioners are“speculators”, trading currencies without any underlying, attached asset. In trying to forecastexchange rates, the forecaster is effectively trying to predict the sum of the intentions, viewsand trading styles of all such currency market practitioners, which is why such disciplines asflow analysis, technical analysis and behavioural finance – or the psychology of the market –come in particularly handy. Newspapers and newswires frequently describe market movementin emotionally laden terms such as “panic”, “sentiment” and “market psychology”. At the endof the day, currency market participants are human beings. They act or react according to theirown views, their own biases, and their own “skews”. Just as information is not perfect, so theway information is interpreted is often skewed one way or another. The field of behaviouralfinance has done much generally to illuminate the psychological aspects of financial marketactivity and more specifically to demonstrate the kinds of mistakes that market participantstend to make on a consistent basis. Active currency market participants would do well to learn
238
Conclusion
and remember these for the purpose of avoiding them in future. Market “sentiment” can bea powerful thing. It can continue and extend far beyond any fundamental valuation, and ofcourse the longer it does that the more powerful the snap back when it eventually comes.In the end, it comes down to that most economic of concepts, incentive. Speculators, whomake up the majority of the currency market, trade for the most part for the purpose of capitalor directional gain rather than income. The incentive of the interbank dealer is that of a surfer,to ride the waves of liquidity that ebb and flow in the market, for the most part offsettingclient flows, sometimes taking positions either in their favour or against them. Split-secondtiming and reactions are needed, and mistakes are punished. Equally, traders need to tradein order to make a living, even in the absence of fundamental changes in the economy. Defacto, at those times when there is no fundamental change, they have to rely on other types ofanalysis to explain and forecast price action. It is no coincidence that technical analysis hasso deeply penetrated the interbank dealing community. That is not to say interbank dealersignore fundamentals. Rather, it is to say that their job requires they look at more than justfundamentals and specifically those types of analysis that might be better suited to short-termexchange rate movement. In short, the people who devise these exchange rate models shouldspend time on a dealing floor before they finish their work.Lastly, a key aspect of this book is that I have attempted to be much more user friendly thanthe works on currency markets that I have been used to. These days, it is not enough to trot outtheory and leave it to the client to extrapolate some practical meaning. Anyone can do that. Itdoes not add value. Instead, as noted above, through this book I have tried to bridge the gapbetween economic theory and market practice. It is my hope therefore that the people whoreally matter, the practitioners of the currency markets, be they corporate Treasurers, investorsor speculators, will have benefited in a measurable and practical way by the experience inmanaging their own respective currency risks. It is this aspect in particular which I hope hasdifferentiated this book from the vast majority of books and research papers on the subject ofexchange rates.
Indexabsolute returns, 165–7, 215–16active currency management, 169, 172–6AFTA, 138‘alpha’, 169–71, 205, 216–17, 227animal spirits see flowArgentina, 204, 232peso, 110ASEAN, 138Asia, 12, 36, 68, 119Asian crisis, 31, 62, 110, 115, 122, 188–9, 205,230Asian currencies, 228–30Asian non-deliverable forward (NDF), 230–1asset and liability management, 214Australian dollar, 57, 228average rate options (AROs), 159baht, Thai, 27, 115, 121, 189Balance of Payments Approach, 34–42, 211Bangkok International Banking Facility (BIBF),122Bank of America, 53Bank of England, 2, 40, 69, 189Bank of International Settlements, 2, 7, 191Bank of Japan, 72Bank of Thailand, 188–9bar chart, 92, 95bearish divergence, 100behavioural finance, 67, 202benchmark hedge ratio, 182–3benchmarksblended, 226for currency overlay, 181–2for currency risk management, 153–4declining returns on, 204–5Berlin Wall, demolition of, 6–7‘Big Mac Index’, 20, 22–4bilateral asymmetry, 170Black Wednesday, 2
bolivar, Venezuelan, 38, 110Brazil, 12, 68, 110, 119, 124, 226, 232real, 27, 56, 57, 76Bretton Woods system, 6, 11, 17, 34, 48, 83, 107,118, 180, 233budget exchange rate, 154–5, 214–15Bulgaria, 232Canadian dollar, 57candlestick chart, 92, 94capital flows, 110–11capital mobility, 114carry trade, optimization of, 175–6, 217–18charting, 87–100, 210–11currency order dynamics and technical levels,87–9psychological levels, 90–100trends, 90Chicago Board of Trade, 69Chicago Mercantile Exchange, 69Chile, 110, 232China, 29, 36, 229yuan, 121, 228, 229, 230, 231CitiFX Flows, 5, 72–5Citigroup, 76classic accounting identity, 34Classic Emerging Market Currency Crisis(CEMC) Model, 11, 117, 119–28, 131,212–13, 219–20Colombia, 39, 110convertibility risk, 177“Core Principles for Managing Currency Risk”,144–5corporate risk optimizer (CROP), 152–3corporate treasurers, 195–6corporation and predicting exchange rates, 155covered interest rate arbitrage, 32Croatia, 232cross-border investment, 204
240
Index
crossover investors, 225, 226crawling pegs, 111, 112currency analysis, integrated approach, 200currency board, 112currency economics, 5, 10, 47–64, 209currency hedging, 146–7, 220–4benchmarks, 167–9, 216bid-to-award risk, 159–61budget rate and, 158–9currency optimization, 152–3currency overlay, 179–85benchmark, 181–2benchmark hedge ratio, 182–3history and basics, 179–80investment styles, 183–4key issues, 181–3return diversification, 180–1tracking error, 182underlay, 183currency riskcore principles for managing, 144–5managing, 143, 180measuring, 143–4tools for managing, 147–8currency speculation, 13, 199–202history, 203–4investment trends, 204–6currency strategy, 218–24Cyprus, 232Czech Republic, 31, 110, 113, 232koruna, 45, 57, 188, 222Daewoo, 126dedicated investors, 225, 226defined benefit (DB) pension, 180, 181defined contribution (DC) pension, 180, 181Deutsche Bundesbank, 2, 31, 113Deutschmark, 2, 31, 187, 188differential forward strategy, 172–3, 217direct investment flow, 45divergence, 100dollarAustralian, 57, 228Canadian, 57New Zealand, 57, 228Singapore, 57, 125Taiwan, 231US, 5, 8, 9, 26, 28–9, 40, 43, 57, 60–1, 83,131–2, 180, 182–3, 203–4, 222, 230, 237Dornbusch, Rudiger, 26double average rate option (DARO), 154Dow, Charles, 85Dow Theory, 85EBIT, 150EBITDA, 150
economic currency risk, 142–3, 213Economist, The, 22Ecuador, 110Efficient Market Theory, 4, 48–9Elliott Wave Theory, 101, 102, 210Emerging European currencies, 231–2emerging markets, 38, 109–10, 162, 176–8, 203,205–6, 225–33as asset class, 225–7currencies, 227–8EMFX Flow Model, 76–7equity flow, 45Estonia, 232Euro, 2, 11, 31, 40, 56, 72, 73–4, 108, 222, 231–2European Central Bank, 83, 237European Monetary System, 6European Union (EU), 41, 56, 232new member states 31Euro-Zone portfolio flow report, 79exchange controls, 177exchange rate mechanism (ERM), 2, 11, 13, 107,116, 132, 187–8, 189–90, 192, 203–4crises 1992 and 1993, 6, 11, 31, 69, 115, 187ERM II, 31exchange rate regimes, 11, 110, 111–18, 212fixed, 24, 27, 35–6, 111–14freely floating, 24, 27, 36–7, 112–13, 128–33,212pegged exchange rate regimes, 111–14, 212realworld relevance, 116–18sustainability, 114–16exchange rates, 1drivers of, 44–5real interest rate differentials and, 34“external imbalance”, 38Federal Reserve, 28, 36, 45, 61, 86, 130, 226, 237Federal Reserve Bank of New York, 10, 40, 67,69, 86Fibonacci, Leonardo, 100–1, 210Fibonacci fan lines, 101Fibonacci retracement, 101Fibonacci sequence, 100–1, 210Financial Accounting Standards Board (FASB),156FAS, 133, 156, 158financial development, 114first-generation crisis models, 132Fisher, Irving, 32Fisher Effect, 33fixed exchange rate regimes, 24, 27, 35–6,111–14fixed income flow, 45floating exchange rate regimes, 24, 27, 36–7,128–33, 212fear of, 112–13
Indexflow, 65–84medium-term flow models, 77–81option flow/sentiment models, 81–2proprietary models, 72–5short-term emerging market flow models, 76–7short-term models, 70–7speculative and non-speculative, 82–4flow analysis, 5, 10, 207, 209–10forecasting error, 159, 171, 217foreign direct investment, 204forint, Hungarian, 45, 56, 57, 222forward rate bias, 155, 172–3, 177frame dependence, 202Frankel, Jeffrey, 26Friedman, Milton, 113fundamental analysis, 9, 15–45Fundamental Equilibrium Exchange Rate(FEER), 38–9Gann analysis, 210Gann angles, 101Gann lines, 101Gann theory, 101–2Glasnost, 6Global Hazard Indicator, 53Golden ratio, 101Gorbachev, Mikhail, 6Gulf War, 131hedge accounting, 156–8hedge funds, 194–5, 205hedging, 165balance sheet, 150–1currency, 146–7, 220–4economic exposure, 151emerging market currency risk, 153internal, 214matched, 171–2, 214natural, 68transaction risk, 148–50hedging structuresenhanced, 149traditional, 148heuristic-driven mistakes, 202Hong Kong, 36, 110, 204, 230, 236Hong Kong Monetary Authority, 236Hungary, 31, 110, 113, 232forint, 45, 56, 57, 222IMM Commitments of Traders Report, 69, 70–2,210India, 24, 229, 231Indonesia, 36, 39, 189, 231rupiah, 27, 115, 125, 189, 198inflation, 114, 177Instability Index, 53–5, 201
241
interbank dealers, 192–3Interest Rate Approach, 32–4, 211interest rate parity theory, 32–4International Accounting Standards Board(IASB), 156IAS39, 156–8international equity funds, 168International Fisher Effect, 33, 34, 142, 177International Monetary Fund (IMF), 65, 69, 109,113, 117, 124, 133, 188, 225Quarterly Report on Emerging MarketFinancing, 79–81investor herding, 5invoicing in foreign currency, 214Israel, 24Japan, 5, 21, 40, 41, 63government bonds, 42–3yen, 4–5, 40, 43, 37, 56, 74–5, 121, 228, 229,230J-curve, 62–3Keynes, John Maynard, 9, 47, 65Korea, 36, 62, 126won, 27, 115, 231korunaCzech, 45, 57, 188, 222Slovak, 56, 222Krugman, Paul, 26Krung Thai Bank, 126labour market flexibility, 114Latin American currencies, 232Latvia, 232LCPI Index, 53leading and lagging, 214line chart, 92, 93liquidity risk, 176lira, Turkish, 219–21Lithuania, 232Louvre Agreement, 6, 203LTCM failure, 194Lucas, Edouard, 101Maastricht Criteria 31, 232macro hedge funds, 198Malaysia, 69, 110ringgit, 125, 230Malta, 232managing currency risk, 12, 13corporation and, 137–62, 213–15investor and, 157–85, 215–18speculator and, 187–208, 218matched hedging, 171–2, 214Mexico, 12, 39, 68, 109, 110, 119, 204, 232peso, 38, 45, 56, 57, 76, 116, 138, 188, 237
242
Index
model analysis, 11, 119–33momentum funds, 198–9Monetary Approach, 25–31, 211monetary credibility, 114Morgan, J.P., 53moving average, 92, 96, 103moving average convergence divergence(MACD) indicator, 97–100Mundell-Fleming model, 27–9, 30–1, 36, 43, 110NAFTA, 138, 232NASDAQ, 158, 194National Bank of Poland, 50, 127, 128, 129“natural” hedging, 68netting, 214New York Stock Exchange, 69New Zealand dollar, 57, 228Nigeria, 39non-deliverable forward (NDF), Asian, 230–1Norway, 39off index allocation, 225operational controls, key, for Treasury,147, 214optimization model, 214option analysis, 207option risk reversals, 210order flow models, 210oscillator, 97passive currency management, 166pegged exchange rate regimes, 111–14, 204pension funds, 180, 181Perestroika, 6performance benchmarks, 147Peruvian sol, 45, 237pesoMexican, 38, 45, 56, 57, 76, 116, 138, 188, 237Philippine, 125Philippines, 231Plaza Agreement, 6, 28–9, 203Poland, 31, 50–3, 110, 113, 232zloty, 45, 51, 56, 57, 81, 129, 237Portfolio Balance Approach, 42–3, 44, 211position limits, 147position monitoring, 147price adjustment, 214productivity, 40–2proprietary dealers, 193proprietary flow models, 72–5Purchasing Power Parity, 3, 7, 17–25, 32, 33,34, 38, 40, 117, 142, 161, 211, 213–14,215corporate pricing strategy and, 20–4misalignments, 19
real exchange rate and, 24–5tradable and non-tradable goods, 20rand, South African, 76–7random walk theory, 44, 87, 102real, Brazilian, 27, 56, 57, 76Real Effective Exchange Rate (REER), 3, 38–9,63–4, 117, 161, 233relative returns, 169–72, 203relative strength index (RSI), 97, 98resistance in technical analysis, 87–9ringgit, Malaysian, 125, 230risk appetite, 201risk appetite indicators, 53–8, 161–2, 211–12risk reduction, 166–7, 215–16risk reversals, 81–2Romania, 232rouble, Russian, 27, 38, 190rupiah, Indonesian, 27, 115, 125, 198Russia, 12, 39, 68, 110, 117, 119, 204, 232rouble, 27, 38, 190Salomon Smith Barney, 53second-generation crisis models,132–3sentiment models, 81–2, 210Sharpe’s ratio, 158, 166, 217Signal Grid, 13, 211Singapore dollar, 57, 125Slovakia, 31, 232koruna, 56, 222Slovenia, 23