itable – signal. In this example, the Japanese authorities, in the form
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of both the Bank of Japan and the Ministry of Finance, had signaled that they were in favour ofa weaker yen, in line with the weak Japanese economic picture. The ability of either monetaryor fiscal policy to be eased further had been all but eliminated. The only lever left for furtherpolicy easing was the yen itself. This idea caught on within the speculative community, with theresult that speculators closed out their short dollar–yen positions and created an increasinglylarge long dollar–yen position, as reflected by the IMM data. As an analyst or as a currencymarket practitioner such as a corporation or an investor, one can use this information in thefollowing ways:
r Analyst – Review the flow and fundamental economic data to come up with an overall pictureof the short-term flow and fundamental dynamics in the dollar–yen exchange rate and thusthe ability or not of the prevailing trend to continue.r Trader – As the prevailing trend continues and increases in the dollar–yen exchange rate,position to take advantage of the reversal when it comes.r Investor – Use the combination of flow and fundamental data as a guide in determining yenexposure and hedging policy with regard to that exposure.r Corporation – Use the combination of flow and fundamental data as a guide for short-termhedging policy.To reinforce the point of the usefulness of this data, let’s quickly look at another example.If we look at the position in Euro futures, we see that the net position as of November was netshort −286 contracts. On the face of it this may suggest that there is no directional bias forthe Euro–dollar exchange rate near term. However, it is important to note that the speculativecommunity had a net long Euro position in the IMM futures contract for much of Augustthrough mid-November. Indeed, the Five-year high for Euro longs was hit on August 28 at31,666 contracts. Since then, there was a gradual reduction in the speculative long position inEuro futures. In line with this, spot Euro–dollar came under increasing selling pressure. Thus,noting that there was such a large net long Euro position at the end of August, one could havepositioned to anticipate a retracement in spot Euro–dollar in anticipation of those positionsbeing closed out. Equally, the fact that this net long Euro position switched to a small net shortconversely gave the Euro–dollar exchange rate some support as this overhang of long positionshad thus been eliminated.Proprietary Flow ModelsNowadays, a large number of commercial and investment banks have their own proprietaryflow models, which track the foreign exchange activity of their global client base. Dependingon the size of the bank and therefore of that client base, these can be very useful and informativemodels. One of the better known flow models is the CitiFX Flows advisory service, whichtracks the foreign exchange flow activity of the Citigroup global client base. Within this, thereare three types of model, which are used concurrently to generate the results:
r Simple linear models – These are autocorrelation models, which are based on the shortterm momentum of flow. Thus, this type of model suggests for instance that if there werebuyers yesterday in a specific currency, there is consequently an increased chance of buyersappearing tomorrow and so forth.r Complex non-linear models – These are error-correction models, which focus on flow thathas been carried out in the past, but is not yet fully reflected in the price.
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r Time-delay models – This focuses on the flow that has passed through in the recent pasthaving important information about the future movement in the exchange rate. CitiFX Flowsanalyses foreign exchange client flows globally in order to try to decipher two hidden trends:r Client flow as an indicator of the underlying currency market momentumr Client flow as an indication of outstanding positions in the currency marketClient flow has become an important component of the overall strategic view, in line with theincreasing opinion to see flow as an important explanatory factor for price change. Liquidityhas become a much-discussed topic and flow models are now a critical input of the overallcurrency strategy process.Proprietary FX flow models generally produce:
r Trading signals based on one month’s worth of flow datar Overweight or underweight indicators based on six months’ or one year’s worth. In line withthis, such FX flow models are also frequently used as trading models, using the client flowdata as trading signals.In the example in Figure 3.1, CitiFX Flows shows global client flow going through theEuro–dollar exchange rate over the time period from August to October 2001, comparingthat flow against the spot Euro–dollar exchange rate. Looking at the last month’s worth offlow in this example, we see a consistent picture of the flow model’s client base selling theEuro–dollar exchange rate. As an example, in the wake of this, the flow model issued a sellrecommendation on Euro–dollar. Such sell recommendations last for one month. Since theirinception, such bank proprietary flow models based on client flow have frequently generatedconsistent excess returns.Such flow models also frequently publish more medium-term exposure indicators, the aimof which is to look for large over- or underexposures, which may over time “revert to mean”.This is again most easily explained using a chart. While Figure 3.1 provided a good flowpicture over the short term, showing increasingly heavy selling of the Euro–dollar exchange
Figure 3.1 CitiFX Flows: example 1a
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Currency Strategy
Figure 3.2 CitiFX Flows: example 1b
rate by the flow model’s global client base, Figure 3.2 takes a longer-term perspective offlow trends. More specifically, it compares the Euro trade-weighted exchange rate against themedium-term Euro exposure indicator. Obviously, before the January 1, 1999 start to the Euroas a tradable currency both measures are synthetic. Here we see that the model’s client baseexposure to the Euro has continued to move to a medium-term underweight from mid-2000onwards, despite the fact that during this time the trade-weighted Euro remained relativelystable. We can derive from this that at some stage reversion to mean will require Euro buyingto close that significant underweight exposure of 1.5 standard deviations. What such a chartdoes not tell us, unfortunately, is when that might happen. Combining the two charts, however,we get a picture both of the short-term flow momentum and of the medium-term positionalconsiderations. Together they can help to provide a relatively exhaustive flow picture of anexchange rate. This in turn can provide both trading and hedging signals.In order to reinforce the point, it is probably useful to conduct the same exercise usinganother currency. In the following example, we look at the Japanese yen. Figure 3.3 looks atthe short-term flow picture against spot price action in the dollar–yen exchange rate. Figure 3.4looks at the medium-term exposure indicator of the market as reflected by the model’s clientbase as against the medium-term trend in the trade-weighted value of the yen. Comparingthe two charts, we get a very informed picture of the flow vs. the spot price action in theJapanese yen. In the case of Figure 3.3, the thing to note is that the flow was largely in linewith the spot dollar–yen price action. More interesting is the fact that the flow continued toshow heavy selling of dollars against the yen even in the face of adverse price action. Fromthis, the CitiFX Flows team put out a recommendation to sell the dollar–yen exchange rate.Figure 3.4 shows the more medium- to long-term flow picture in the yen. Through mid-1998,the exposure indicator showed an increasing underweight position in the yen. From then on,the underweight was continually reduced until mid-1999 when it flipped to an overweightposition. Medium-term exposure indicators are useful in that they imply a reversion to mean,and in this case that would mean the flow moving back to a more neutral reading, which would
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Figure 3.3 CitiFX Flows: example 2a
Figure 3.4 CitiFX Flows: example 2b
require significant selling of yen. Thus, combining the two, we get a picture of short-termflows favouring a lower dollar–yen exchange rate, but the medium-term flow picture favouringa potentially significant rebound in favour of the dollar.Short-Term Emerging Market Flow ModelsThe academic community and financial market participants have finally come around to theidea that tracking capital or order flow in the developed world currencies was an important thing
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to do. Given the depth and liquidity of developed world markets, this fact may be surprisingto some. However, as we have attempted to show above, this is nevertheless the case.Where it is true in the developed world markets that watching flow is an important pursuitin determining the exchange rate path, this is even more the case in the so-called emergingmarkets. Here, the relationship between individual capital flows and overall market liquidityis much more in favour of individual flows. Liquidity in emerging markets is by definitionsubstantially less than in the developed world. Thus, individual flows can cause substantialprice disruption in emerging markets, whereas they might be more easily absorbed in thedeveloped markets. For this very reason, it is important for currency market participants whoare involved in or exposed to emerging market currencies to have a reasonably accurate ideaof the prevailing type of flows going through the market. One such is the EMFX Flow model(Robert Lustberg and Callum Henderson, 2001) created to track client flows going throughthe global dealing rooms of Citigroup in emerging market currencies. The type of informationthat one can glean from this is the following:
r Total flow – The total flow indicator looks at cumulative transactions in the currency concerned against all the major base currencies (such as the Euro, dollar, yen, sterling and Swissfranc) combined. This gives an accurate indication of the client’s base total exposure to thatcurrency.r Short- and medium-term flow indicators – The short-term flow indicator examines flowgoing through a specific exchange rate over the period of one month, while the medium termflow indicator does this over six months.r Client-type flow – It is also useful to look at what types of clients are doing what. Forinstance, one can see whether or not corporate hedgers are being particularly active in acurrency or not, or whether or not there is substantial speculative flow.The use of such a flow model is to realize flow trends, in some cases confirming through themodel what one knows anecdotally, and then make formal trading recommendations on theback of that. Some of the major finds in 2001 from this work were the following:
r Brazilian real – Corporate hedging was the main flow dynamic of the dollar–real exchangerate for much of 2001. Examining the model’s findings we saw that the consistency ofhedging activity, which entailed buying of dollars, and the quality of the types of corporationshedging, strongly suggested the dollar–real exchange rate would continue to appreciate.Equally, during November–December, when these corporations were no longer rolling theirhedges it was no coincidence that the dollar–real exchange rate stabilized and retraced lowerin favour of the real.r Mexican peso – Through the first eight months of 2001, client flows going through thedollar–peso exchange rate were largely in favour of the peso, confirming the anecdotal viewthat foreign direct investment remained a major supportive factor for the peso, more thanoffsetting the current account deficit. From October on, however, local corporations as agroup turned net buyers. This did not cause an immediate appreciation in the dollar–pesoexchange rate, but did put a floor under it and caused it to appreciate over time.r South African rand – There has been over the past few years much controversy regardingthe flows going through the rand. Local market participants in South Africa have largelyblamed the offshore market for rand weakness, while the economic community has been ata loss to explain rand weakness given the country’s “strong economic fundamentals”. Fromthe EMFX Flow model, we discovered that the client flow of the bank had an asymmetric
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relationship with the price action of the dollar–rand exchange rate. That is to say, when clientswere net sellers of dollar–rand – which was most of the time – the exchange rate remainedlargely range bound. On the other hand, during rare periods when clients became net buyersof dollars against rand, the exchange rate exploded higher. From this we can deduce asimple explanation for the rand’s weakness according to flow – locals are responsible forrand weakness.Such findings can help greatly, not just in terms of providing trading recommendations for thespeculative community, but in helping investors or corporations to plan their hedging strategies.Proprietary FX flow models focus generally on the short-term flow picture. However, thereare flow reports that focus on the medium-term structural flows that go through asset markets.These also reflect useful information. As examples of such medium-term flow analysis, wenow focus on the US Treasury’s “TIC” report and the Euro-zone capital flows report.3.1.2 Medium-Term Flow ModelsThe US Treasury TIC (Treasury International Centre) ReportThe second way we can approach this general issue of flow analysis is to look at the specificcapital flows going into equity and fixed income markets. Here the availability and quality ofthe data vary widely. For instance, there are data reports focusing on what amounts of moneyare going into mutual funds. From this, we can of course break those mutual funds down intoinvestment types – equity or fixed income, the destination of the investment and so forth.Why these flows move over shorter periods of time depends as much on market psychologyas economic fundamentals – but how does market psychology work? Moreover, why does amarket that is impacted by some political and economic factors at one time then completelyignore them at another? To a large extent, the answer must lie in the very structure of theglobal currency market. While many people focus – rightly or wrongly – on hedge funds asbeing dominant currency market players, on any given day the vast majority of transactionsare between banks, or “interbank” in market jargon. Hence, bank spot and forward dealers areby a long way the largest single player in the currency market. No one model has been able toforecast exchange rates accurately, because no one model has been able to predict accuratelythe sum of their intentions, behaviour or feelings towards the market. Yet, while that is the casethere are some generalizations we can make about market behaviour given its participants.Firstly, traders have to trade in order to make a living. Hence, even in the absence of marketmoving news or economic data, these traders still have to trade. This is of course linked inwith the increasing use of technical analysis. As more people use this and more people watchcertain levels, so those levels become more important. Needless to say, a break of those levels,one way or the other, thus leads to herding activity.There is another aspect to market psychology and it is that markets, just as economies,also trade in cycles. This is not necessarily to say that the two cycles occur over the sametime period. Obviously, this is a subject that will be covered more fully in this chapter, but tosummarize briefly the longer a cycle continues, the more self-fulfilling it becomes. Speculativeelements are increasingly attracted by what appears to be a one-way bet. Of necessity, the typeof activity that this reflects is trend following. The rule of trends is that they have not ended untilthey have ended. In other words, until there is clear evidence that the trend is over, the marketcontinues to buy into that trend. However, such financial market trends have impact in the realeconomy. If the trend represents capital inflows, then it causes the current account balance to
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Table 3.2 US Treasury “TIC” (Treasury International Capital) Movement Data as of August 2001Net foreign inflows into long-term US assets (USD billions)Monthly net flows
Quarterly average net flows
Asset class
August
July
June
Q2-01
Q1-01
Q4-00
TreasuriesAgenciesCorporatesTotal fixed incomeStocksTotal US assets
4.4011.9112.7129.028.5937.61
−11.4912.4814.3715.3511.4826.82
−3.4516.9115.5629.0210.4439.46
−4.6913.1123.9732.3911.4643.85
0.9714.0923.2838.3513.8952.24
−8.9615.4917.1523.6812.1735.85
Europe
Asia
Latin America/Caribbean
Asset class
August
July
August
July
August
July
TreasuriesAgenciesCorporatesTotal fixed incomeStocksTotal US assets
0.311.927.649.869.0618.92
−8.224.607.313.686.7010.39
0.584.832.728.121.449.57
−3.946.801.674.533.738.26
3.725.553.4012.67−3.069.61
1.891.025.218.120.078.18
become an increasingly large deficit. Increasing fundamental deterioration is initially ignored,but after an extended period of time two things start to happen – the size of the current accountdeficit becomes alarming and investors start to get nervous as a result. Real money investorsstart to pare back their positions, but speculators continue to pile in. Towards the end of a trend,volatility starts to pick up markedly, until such time as an unforeseen catalyst causes the trendto end abruptly and violently. Indeed, the longer the trend has gone on, the more people are inthe trend, and thus the more violent the trend reversal. Yet, just as trends are self-fulfilling, soare trend reversals, which in turn become new – if opposite trends; so works the market cycle,according to technical rather than economic factors.Cross-border flows are also driven by fundamental considerations such as:
r Portfolio diversificationr Maximizing total returnsr Specific investor risk tolerance levelsWhen it comes to investment, these are important incentives and guidelines. Our purposehere is to track not incentives but actions. Thus in our first example we look at the US Treasury’s“TIC” report, which examines portfolio flows by non-residents of the US going into the USequity and fixed income markets. As we have seen, as barriers to capital have fallen acrossthe world, so capital flows have become increasingly important in determining exchange rates.The usefulness of this report is in explaining and confirming medium-term flow trends eitherin favour or against the US dollar in this case. Thus, as an example, Table 3.2 shows the TICreport from August 2001.44
US Department of Treasury TIC Report, August 2001.
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79
From this we can tell a lot of useful information. For instance, we can note that total foreigninvestor inflows to the US asset markets rebounded in August to USD37.6 billion, after fallingsharply in July to USD26.8 billion from USD39.5 billion in June. There are both negativesand positives from this. On the negative side, this USD37.6 billion was a rebound from a14-month low in July and also well below the USD48 billion monthly average for the first halfof the year. On the positive side, this month-on-month increase happened at a time of USDweakness. A major positive swing in favour of US Treasuries was largely behind it, from atotal of –USD11.5 billion in July to +USD4.4 billion in August. Agencies, corporates and USstocks all saw modest declines in net inflows from non-US accounts.Looking at the regional breakdown, the largest swing in favour of Treasuries was by Europeanaccounts, though the largest absolute buying was by Latin American/Caribbean accounts, whichare usually dominated by offshore hedge funds. For the US dollar to trend lower requires thatinflows to US assets also trend lower, and as of this report those conditions had not been met.Thus, comparing the spot price action in dollar exchange rates to the table, we see a flowconfirmation of what many in the market called the “surprising” resilience of the US dollar.Subsequent TIC reports from the US Treasury confirmed the US dollar strength through earlyDecember, despite the accelerated deterioration in US economic fundamentals. The flow picturethus explained the strength of the US dollar where just using the fundamental picture did not.The Euro-Zone Portfolio Flow ReportThe Euro-zone capital flows report for September 20015 shows that the Euro-zone, whichhad been recording monthly capital outflows (combined direct and portfolio investment) from1999 through the first half of 2001 started to record capital inflows in the second half of 2001and in September of that year saw the second highest monthly inflow since the establishmentof the Euro in January 1999. This was also the fourth consecutive net inflow. Comparing thefirst nine months of 2001 to 2000, the total net outflow fell to EUR51.3 billion from EUR87.5billion, an important reason for the Euro’s more stable performance. See Figure 3.5.Within this overall flow picture, as we see in Figure 3.6, net fixed income inflows rosesubstantially to EUR16.6 billion in September, a five-fold increase from the previous month’ssmall inflow. Indeed, for the first time since the inception of the Euro in January 1999, theassets side of total portfolio investment (Euro-zone-based investors) switched to net inflows inSeptember 2001.Finally, equity flows recorded a net inflow for the fifth straight month in September risingto more than double August’s level at EUR28.3 billion. All of this helps to support a pictureof an improving flow story for the Euro in the second half of 2001. This does not definitivelysuggest on its own that the Euro should appreciate against its major currency counterparts. Itdoes appear to suggest however that the Euro should at the least be more stable – and this ismore or less what happened, excluding the specific volatility caused by the tragic events ofSeptember 11.The IMF Quarterly Report on Emerging Market FinancingWithin the emerging markets, the International Monetary Fund produces a quarterly report onasset market-related flows, which is available on the IMF website. As an example of this, we can5
Euro-zone Capital Flows Report and European Central Bank, September 2001.
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Currency StrategyEMU Direct & Portfolio Investment Inflow Accelerates60504030
EUR (billions)
20100−10−20−30−40−50−60
J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O990001EMU Direct + Portfolio Investment (Net)EMU Current account
Figure 3.5 Euro-zone capital in flowsEMU Fixed Income Inflow (Bonds & Notes) Surges20
7
EUR (billions)
10
06−10
−20
−30
J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O990001EMU Portfolio investment, debt instruments, bonds & notes
Figure 3.6 Euro-zone fixed income inflows
5
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81
take a look at the Q3, 2001 report,6 which appeared to confirm that the events of September 11significantly increased investor uncertainty and reduced risk tolerance at a time when marketconcerns were already high about global slowing, emerging market fundamentals and thepotential for credit events in particular emerging markets. There was an across-the board selloff of emerging market assets and at least initially an ensuing drought in new bond issuance.In terms of the flow trends at work, the major symptoms were a broad-based sell off inemerging market assets, thus increasing the correlation between individual market returns and ageneral “flight to quality” among investors within the credit spectrum. Treasuries outperformedcredit product for this reason. Some credit or spread products outperformed others, suggestingthat the sell off was not entirely panic-driven and that some degree of differentiation wasmade. Not surprisingly, financing by the emerging markets on international capital marketsfell sharply in Q3 to issuance levels not seen since the Russian crisis in the autumn of 1998.More specifically, bond issuance more than halved from levels seen in Q2.The Emerging Market Financing report examined in depth two issues:
r The report examined in detail the investor selection and discrimination process within emerg-
ing fixed income markets. The sharp fall in investor risk tolerance was found to be a crucialdetermining factor in the parallel decline in bond issuance.r The report suggested that, based on trends through the end of Q3, net capital flows to theemerging markets were set to turn negative for 2001 as a whole for the first time in more than10 years, and then goes on to look at whether the rise in private sector capital inflows to theemerging markets in the 1990s was a cyclical phenomenon or due to temporary factors, theend of which may or may not have been signaled by the fact of negative inflows in 2001.These are the kinds of issues that the IMF’s quarterly review of Emerging Market Financingdeals with. It is an excellent and exhaustive report, which shows the medium-term trends inequity, fixed income and lending flows for the emerging markets. It is useful not so much forshort-term traders, but rather for corporations or institutional investors who require a detailedmedium-term flow picture before making their investment decision, or alternatively requireinformation that will help in deciding whether or not to hedge or reduce currency exposure.3.1.3 Option Flow/Sentiment ModelsRisk ReversalsIn addition to flow indicators, there are also sentiment indicators. These do not reflect flowsdirectly going through the currency market, but more indirectly by representing the market’sbias towards exchange rates. A very useful indicator of market sentiment or “skew” is theoption risk reversal. This is the premium or discount of the implied volatility of a same deltacurrency call over the put. For instance, a dollar–Polish zloty three-month risk reversal maybe 3 vols, which means that the implied volatility on the 25 delta three-month US dollar callcosts 3 vols more than the 25 delta dollar put against the Polish zloty.Table 3.3 looks at the risk reversals for the major exchange rates and the US dollar–zlotyexchange rate. Given that it provides risk reversals across tenors, this produces in effect a riskreversal “curve”. How do we interpret this information? Clearly, the best way of doing so isby comparing current to historic levels. In this case, one should compare the current levels ofoption risk reversals as expressed by the table results to a historic measure of risk reversals forthose same currency pairs.6
IMF quarterly report on Emerging Market Financing, Q3, 2001.
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Table 3.3 25 delta risk reversalsEUR– USD– GBP– EUR– EUR–USD JPYUSD JPYGBP1M 0.15EURcall3M 0.25EURcall6M 0.25EURcall1Y 0.25EURcall
0.7JPYput0.5JPYput0.4JPYput0.35JPYput
0.4GBPput0.2GBPput0.35GBPput0.35GBPput
0.2EURcall0.2EURcall0.2EURcall0.2EURcall
USD– AUD– USD– EUR– EUR– GBP– USD–CHF USD CAD SEK CHF JPYPLN
0.20.15around CHFcall0.250.25EURCHFputcall0.150.3EURCHFputcall0.250.2EURCHFputcall
0.5AUDput
0.5USDcall
0.3EURcall
0.7EURput
0.35GBPput
1.8USDcall
Options are priced off forwards and through this option risk reversals are priced off interestrate differentials. How do we price interest rate differentials? A key determinant for both thelevel and trend of interest rates is the current account. A current account surplus results ingreatly increased liquidity, which in turn pushes interest rates lower. Equally, a current accountdeficit is an important factor in pushing interest rates higher. From this, we can say that termcurrencies with current account surpluses usually have the risk reversal in their favour. Thus,the dollar–Swiss franc exchange rate risk reversal should usually be in favour of Swiss franccalls. In other words, Swiss franc calls should be more expensive than Swiss franc puts. Equally,the same should usually be the case for dollar–yen risk reversals. If at any one time they arenot, then this may represent a profitable trading or hedging opportunity.Looking at Table 3.3, we see that Euro–dollar risk reversals are bid for Euro calls, whichshould be the case given relative interest rate differentials and current accounts. However,comparing this situation with how Euro–dollar risk reversals traded in the prior weeks beforethis report, a picture emerges of the options’ market gradually reducing its bias in favour of Eurocalls. The risk reversal was substantially more in favour of Euro calls and has been reduced.Thus, it is important not just to look at current risk reversal levels, but also to compare themwith where they have been in the past. Historically, the one-month dollar–yen risk reversal hasusually been around 0.4 in favour of yen calls given the interest rate differential and Japan’sstructurally high current account surplus. In 2001, Japan saw its current account surplus declinefrom USD12.6 billion to USD9 billion, or from 2.5% of GDP to 1.8%. As a result, “fair value”for the dollar–yen one-month risk reversal probably fell to around 0.3 for yen calls. Notehowever that in the table the entire risk reversal curve is bid for yen puts. Hence, the optionsmarket seems temporarily out of line and may at some stage revert to mean – through yenappreciation and the risk reversal swinging back in favour of the yen. This is the kind ofinformation that one can gain from the risk reversal table.
3.2 SPECULATIVE AND NON-SPECULATIVE FLOWSWhile these flow and sentiment models vary, both in terms of the time span they focus on andthe kind of information they look at, the basic premise behind them is the same – exchange rates
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are determined by the supply and demand for currencies, in other words by “order flow”. Overtime, economic fundamentals will dictate the order flow and therefore the exchange rate itself.However, currency market practitioners do not necessarily have that long to wait. Therefore,it is necessary to study order flow separately and independently from the fundamentals, andmoreover it is necessary to study the drivers of that order flow. That is what we have attemptedhere in this chapter.The key distinction between a speculative and a non-speculative capital flow, keeping to thedefinition that we are using for speculation – which is that speculation involves the buyingand selling of currencies with no underlying attached asset – is the exchange rate itself. Fora speculator, the exchange rate is the primary incentive for investing, using this definition.However, for an asset manager, the exchange rate is not the primary consideration, which isthe total return available in the local markets. As the barriers to capital have broken down andas currencies have been de-pegged and allowed to float freely, so both speculative and nonspeculative capital flows have grown exponentially. There remains a dynamic tension betweenthe two, allowing one or other to be more important