ities in each foreign currency atthe start of every month. The size of the forward or option is not changed subsequently until theend of the next month when “rebalancing” takes place to take account of changes in value of theunderlying and a new forward or option put on for the following month. Typically, end of monthsettlement and “rebalancing” is based on WM/Reuters month-end London closing prices.Tracking ErrorAs we saw in Chapter 8 above, “tracking error” is the difference between the portfolio andthe benchmark return. Tracking error can vary significantly, depending on the currency management style and the hedging benchmark. For instance, it would normally be assumed thattracking error would tend to be greater for an active than for a passive currency managementstyle. This may well be the case. Nevertheless, tracking error can still occur under passivecurrency management. In this case, potential causes of tracking error under passive currencymanagement include different maturity contracts in the portfolio to those of the benchmark,price mismatches between mid and live prices and differences between the benchmark hedgingratio and the portfolio hedge ratio. This last can be a major source of tracking error and so has tobe watched carefully. It can occur for several reasons, such as not including some currencies inthe portfolio hedge ratio for practical purposes due to poor liquidity, proxy hedging or changinghedge ratios relative to the benchmark. In this context, the decision of rebalancing is a trade-offbetween the transaction costs involved and the tracking error generated by not rebalancing.Tracking error can also vary depending on the hedging benchmark. Typically, the trackingerror for a partially hedged benchmark should be less than that for 100% hedged benchmark.As we saw earlier, symmetrical or 50% hedged benchmarks should reduce the tracking errorwhile allowing the overlay manager to participate in both bull and bear markets.After considering the type of benchmark and looking at tracking error constraints, a furtherkey consideration is the currencies that should be included in the benchmark. In theory, theseshould include all the currencies in which the “underlay” is invested to minimize tracking error.However, this is not always practical because it means including currency exposures that arenot easily or efficiently hedged in the market. If this is the case, there are three choices:
r Proxy hedge with other more liquid currenciesr Leave that part of the portfolio un-hedgedr Exclude these currencies from the benchmark at the start
At the end of the day, the decision on which option to take has to be agreed at the start byoverlay and underlay managers.The Benchmark Hedge RatioIn currency overlay, the benchmark hedge ratio is measured by the fraction of the contributionfrom hedging divided by the contribution from 100% hedging, as a percentage. As with thebenchmark itself – fully or partially hedged – the benchmark hedge ratio is a function of the riskappetite of the underlay fund manager. In line with this, different benchmark hedge ratios havedifferent characteristics under different currency market circumstances. For instance, whenthe US dollar is rising – as it has been for much of 2005 – it would be a major positive for
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an overlay programme on top of a US-based underlay to have a fully hedged benchmark anda major negative to have a fully un-hedged benchmark. On the other hand, if the dollar werefalling, the opposite would be true. The 50% or symmetrical benchmark and benchmark hedgeratio thus allows participation in both dollar bull and bear markets. Ultimately, however, itdepends on the skill of the overlay manager as to which of those trends seems most likely and,in turn, how to manage that trend.The UnderlayIn general, overlay managers will not alter their basic style of overlay, which may be take asystematic or a discretionary approach or some combination of the two. However, a furtherimportant consideration is the type of underlay exposure. Typically, this is rather equity or fixedincome. Given that currency as a percentage of asset return volatility is more than twice in fixedincome what it is in equity, this needs to be taken into account when considering matters suchas the benchmark, benchmark hedge ratio and tracking error constraints. Moreover, as we haveseen, fixed income fund managers are much more accustomed to dealing with currency risk andmanaging themselves. Also, fixed income fund managers generally, though not always, tendto take a more discretionary and opportunistic approach towards currency risk managementthan is typically used in most currency overlay programmes. This is a further issue that shouldbe thought out ahead of time.Currency overlay grew on the back of the increasing needs of pension funds to manage theembedded currency risk within international equity investment. As a result, currency overlayprogrammes and mandates predominate with an equity rather than a fixed income underlay.Within this, benchmarks and benchmark hedge ratios for equity underlay can vary significantly,depending on the home country. If the home country has a large, liquid equity market, whichcan potentially offer diversified returns, this in theory decreases the incentive for internationalequity investment. For such markets, the optimum international allocation would be less than50%. However, this may be increased via hedging. In any case, both the benchmark andthe benchmark hedge ratio will relate to the international allocation. The key is not just thedepth of the home market, but the ability to achieve return diversification. The lower thereturn diversification capability domestically, the higher the optimum international allocationin equity and, in turn, the higher the hedge ratio. In sum, for equity underlay, internationaldiversification and currency hedging – in this case via overlay – can significantly reducevolatility and enhance return diversification.Currency Overlay: Investment StylesA final point on currency overlay is the investment approach or style that the overlay manageruses. We have touched on this issue before in this Additional Section, particularly with regardto the contrasting approach to currency risk by currency overlay on the one hand and bondfund managers on the other. Here, we outline the four main approaches or styles of currencyoverlay:
r Fundamentalr Technicalr Dynamicr Option-based
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FundamentalCurrency overlay managers generally use a systematic or model approach to currency risk management rather than a purely discretionary one. Therefore, this first overlay style focuses onusing macroeconomic models to generate buy and sell signals for specific currency pairs. However, the one downside of using this style by itself is that standard macroeconomic data such asbalance of payments, growth, inflation and so on rarely generate buy and sell signals for currencies on a real-time basis, but rather after a potentially considerable lag. As a result, it is probablymore useful to use a fundamental style in conjunction with one or more other overlay styles.TechnicalCurrency overlay managers who use a technical approach or style again tend to rely on models, but this time using signals that are generated from technical analysis and largely ignoremacroeconomic data. That said, some of the most powerful signals are generated when fundamentals and technicals are aligned, so overlay managers would do well to consider using somecombination of both a fundamental and a technical style – in line with the integrated approachto currency risk management that I outlined in detail earlier in this book.DynamicCurrency overlay managers who use the dynamic style of overlay hedge their currency riskactively and “dynamically” and are frequently compared to option delta hedgers. They tend totrade more actively – with a consequent risk of increased tracking error. However, this approachshould also be more able to limit losses, thus helping to reduce overall return volatility. Thedynamic style of currency overlay is becoming increasingly popular within the systematicapproach.Option-BasedFinally, there is an increasing number of currency overlay managers who use an option-basedapproach, looking to exploit relative value in the options markets using implied and historicvolatilities, risk reversals and correlations between options and spot markets.ConclusionCurrency overlay has come a long way from its beginnings in the late 1980s and is now arecognized – and increasingly popular – approach to currency risk management. It started asa response to the specific needs of the pension fund industry who were looking to manageinternational equity investment, but has grown from there. Currency overlay has, for the mostpart, taken a systematic approach towards currency risk management. However, the law offinancial models suggests that if they work – and more importantly if they are seen to work bythe market – they will eventually close the market inefficiencies they were designed to close anddo themselves out of a job. As a result, both overlay and underlay industries should considerthe need for a combination of both systematic and discretionary currency overlay management.Even within the systematic overlay community, there has been an increasing tendency to blend
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styles. Two well-known blended styles are fundamental/technical and value/trend/carry, whichtogether should help to boost returns and reduce volatility.
REFERENCESThe following is a brief list of useful and more detailed works on the subject of Currency Overlay:Jessica James (Ed.) Currency Management: Overlay and Alpha Trading.Xin, Hai. Currency Overlay: A Practical Guide.Neil Record. Currency Overlay.The Frank Russell Company (2000, May). Capturing alpha through active currency overlay.
9Managing Currency Risk III – TheSpeculator: Myths, Realities and How tobe a Better Currency SpeculatorAfter looking at the different worlds of the corporation and the “real money” institutionalinvestor, it would be remiss of us if we did not also look at that of the “speculator”. Fewsubjects related to currency markets cause more discussion, debate or emotion for that matterthan currency “speculation”. Indeed, in the last few years, currency speculators have undergonea notable deterioration in the way they are regarded by a substantial proportion of the academicand official community.It used to be the case in standard economic textbooks that “speculators” were widely viewedas a benign force, providing liquidity to the productive areas of the economy such as manufacturing and services, thus lowering the cost of production. Speculation was seen as a necessarybalancing force in the overall economy, which provided the liquidity not found elsewhere.Those economists who acknowledged that in the currency markets there could be periodic ifbrief divergence from fundamental equilibrium also saw currency speculators as benign in thatthey worked to eliminate the divergence quickly and efficiently, more or less under the efficientmarket hypothesis.
9.1 THE SPECULATOR – FROM BENIGN TO MALIGNIn the last decade however, some have increasingly taken a different view in the wake of onecurrency “crisis” after another. The first real currency crisis of the decade came not in theemerging markets but in the developed world. The ERM crisis of 1992 was a wake-up call tocountries in a number of ways. On the face of it, it was manifested in the form of Scandinaviancurrencies breaking their pegs to the Deutschmark and ERM countries such as the UK andItaly being forced out of the system. Inevitably in the chaos of that time, many wrong lessonswere learned. It appeared that the liberalization of the currency markets had allowed currencyspeculators to become such a huge force that they were now capable of dismantling exchangerate systems and causing the downfall of governments – or at least Prime Ministers. The UKChancellor of the Exchequer Norman Lamont may have been said to have sung in his bathafter sterling was expelled from the ERM, but Prime Minister John Major was not singingthe same tune a few years later when his government was routed more completely than anygovernment this century at the 1997 general elections. Headlines reporting that George Soros’famous Quantum “hedge fund” made around USD1 billion by speculating against sterling onlyserved to reinforce the misconception that currency speculators alone forced sterling out of theERM, that they were indeed large enough to accomplish such a feat.A year later and currency speculators were again on the attack, this time against the ERMsystem itself. Under enormous pressure, after having resisted through intervention for months,in August 1993 the governments of the ERM countries gave in and widened the ERM currency
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trading bands to ±15% from ±2.25%, thus de facto allowing a depreciation of their currenciesagainst the ERM anchor, the Deutschmark. The idea of recrimination after a currency crisis isthought of these days as a feature of the emerging markets, indeed currency crises themselvesare thought of as an emerging market phenomenon. Thus, it is important to remember the senseof outrage, fury and a desire almost for vengeance that permeated official Europe in the wakeof that exchange rate band widening. The enemy of the European project, of the Europeandream of integration and eventual unification was clear, and it was “Anglo-Saxon” speculators.After the ERM crises of 1992–1993 however, it was indeed the turn of the emerging marketsto see one currency crisis after another. Here the sense of betrayal at the hands of the “market”was particularly acute because many emerging market countries had adopted free marketpractices precisely to progress economically and eventually bridge the perceived gap betweenthe emerging and developed worlds. Thus, the 1994–1995 currency crisis in Mexico was a veryrude awakening indeed, not just for Mexico and its neighbours but also for the emerging marketcountries as a whole. After that, came the Czech koruna currency crisis in 1996–1997. Like theMexican peso, it was pegged to a base currency. In the Czech case this was the Deutschmark,and like the Mexican peso it eventually was forced to de-peg from that base currency andpromptly collapsed.In 1997–1998, the Asian currency crisis exploded on the international scene. I remember itin the context that I was living and working in Hong Kong when it took place. It is an importantrealization in discussing the subject of currency speculation that countries facing a currencycrisis experience a stage of siege followed by something very akin to bitter defeat. Blame issought, or more accurately in some cases scapegoats are found. It is easy to forget in the 24/7information society that we now live in just how that time was. It was a time of high drama andhigher emotion. In September of 1997, the IMF held its annual meetings in Hong Kong (forthe most part in the huge, new exhibition and conference centre made famous by the signingof the Handover of Hong Kong from the UK to China in that same year). The Thai baht haddevalued on July 2 of that year and thereafter most Asian currency counterparts followed suit,albeit unwillingly. Answers to this crisis were sought and not surprisingly many were found,of varying accuracy. At those meetings, in front of a packed audience, the Malaysian PrimeMinister Dr. Mahathir Mohammed, in all else a most erudite and educated man, thundered thatcurrency trading was “unnecessary, unproductive and immoral”, that it should be “banned . . . itshould be made illegal”, that the profits of currency speculation “came from the impoverishingof others”.It should be reiterated that it was a time of high emotion, a keen sense of betrayal andgreat pain. Asian economies up until then had been viewed as the model for emerging marketsgenerally within the official community. The World Bank itself coined the phrase the “Asianmiracle” – as close as the official community has ever come to verbal irrational exuberance –to define the Asian boom from 1985 to 1996. Asia was a success story for other regions withinthe emerging markets to only hope of emulating. Indeed, the Asian-related optimism, bothwithin and without, went so far as to have the western media suggest that the economic centreof power was shifting from the West to the East. Given all the fundamental progress madeand the resulting praise globally, how else to explain Asia’s collapse in 1997–1998 other thanby malign, almost “terrorist” means? Indeed, the terrorist analogy was used specifically atthe height of the crisis to describe the suspected hand of unnamed evil forces at work. Whilethe remarks by Dr. Mahathir were undoubtedly the most prominent in reflecting the backlashwithin Asian countries against the perceived evil of currency speculation, they were by nomeans the only example of this backlash. In Thailand, there was talk that the Bank of Thailandwas keeping a “black book” of suspected foreign banks, which had speculated against the
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Thai baht, though the Bank of Thailand denied the existence of such a list. In Indonesia,the Indonesian Justice Minister was reported as considering that currency speculators couldface subversion charges if their activities were found to damage the economy, and that theultimate penalty for economic or political subversion was death. At around the same time,the Indonesian Republika newspaper published a public service announcement featuring awesterner (presumably a currency speculator) wearing a terrorist mask and keffiyah in theform of US 100 dollar bills, with an underlying question “Are you a terrorist of this country?”Indonesians were exhorted to “Defend the Rupiah, defend the nation”. Even in the Philippines,where the authorities had traditionally taken a benign view of market forces, there was somesuggestion of blaming foreign speculators.The effort to find blame for the calamities which befell the region in 1997–1998 reflectednot only the political desire to find convenient scapegoats and lay the blame on others, but alsoa deep sense of injustice and anger at the way Asia had been treated and abused by financialmarkets, at the way much of Asia’s economic progress over decades had been destroyed sosavagely in so little time. Initially, it was more expedient to blame foreign speculators for theAsian currency crisis than to try to discover the fundamental economic reasons why the crisisshould have happened, since the latter might have involved laying some of the blame at the feetof the Asian governments themselves. This was not only for politically pragmatic reasons, butalso more seriously for reasons of political survival. It should be seen as no coincidence thatthe dictator Soeharto was overthrown in the aftermath of the Asian crisis. Equally, in Thailand,a series of corrupt governments gave way to significant political reform and the administrationof Chuan Leepkai. Needless to say, there may have been some Asian governments opposedto such ideas of change, preferring the old social pact of stability and prosperity. The onlyproblem with this was that there was no longer any prosperity. Whoever was to blame for it,the Asian currency crisis impoverished millions. After the crisis, it was said that in Indonesiathe economic work of three decades had been all but wiped out, and that as a result half thecountry lived in a state of absolute poverty as defined by the World Bank, living on USD1 aday.An official backlash against currency speculation was certainly not limited to the Asian crisisor to the emerging markets as a whole. Following sterling’s ejection from the ERM in September1992, the UK government’s first public reaction was to blame the German central bank for eithernot coming to the aid of the UK in defending the ERM parity, or in fact deliberately seekingits ejection. There was talk that the Bank of England was drawing up a list of banks which hadplayed a part in speculating against sterling – a ridiculous measure given that the whole markethad been selling sterling and the Bank of England had effectively been the only buyer. Equally,after the forced widening of the ERM bands to 15% on August 1, 1993, the hysterical reactionby officials within the French and German governments, lambasting the implied devaluation ofthe ERM currencies as the result of nefarious activities by heinous “Anglo-Saxon speculators” –presumably the German officials simultaneously forgetting their own ethnic origins – wouldhave made Asian government comments seem tentative by comparison. Europe’s best andbrightest didn’t only talk either. Some of them sought to punish those who had dared go againsttheir precious plans for currency union, by keeping interest rates at punitive levels subsequentto the band widening – in the process, hurting the “innocent” along with the “guilty”.In Asia, the response was also not just verbal. Thailand created a two-tier foreign exchangeand interest rate system, while the Philippines and Indonesia slapped on limits to swap markettrading and Malaysia went so far as to ban offshore trading in the ringgit and peg it at MYR3.80to the US dollar. While the dividing line is somewhat thin, these measures were not so muchaimed at punishing speculators after the fact, as they were efforts at self-defence during the
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climax of the speculation and panic. The reaction to the Asian crisis by governments wasinitially in many cases one of recrimination, however with one notable exception that eventuallyturned to one of pragmatism and the realization of a need for accelerated reform. The essenceof Asia’s official protest at its rough handling was two-fold: firstly, a natural reaction to suchtreatment whatever the reasons, and secondly an issue of control – the authorities had lostcontrol, or at least a high degree of it, and the market had gained it. Of necessity, control isa subject close to the heart of any government or central bank. This was the case in Europeafter the two ERM crises, and it was also the case with Asia. Control was relevant not onlyfor economic reasons but also because the previously strong growth had masked or postponedunderlying political and social problems.The Asian currency crisis was followed swiftly by the Russian currency crisis of August1998. It is interesting if not amusing to remember now that a high-ranking Russian official saidat the 1997 IMF annual meetings in Hong Kong (which I attended) that the Asian crisis hadprompted a re-think of currency policies generally, and of Russia’s in particular. That Russiawould not act immediately but would clearly have to reconsider their exchange rate policy inthe face of such events. Politicians say a lot of things, but that is not to say that they actuallydo them. In the case of Russia, clearly the process of reconsideration was neither speedynor decisive enough. In August 1998, the Russian rouble de-pegged from the US dollar andcollapsed, and Russia defaulted on its domestic debt. This was followed shortly by a currencycrisis on the other side of the world, in Brazil. In January of 1999, the Brazilian real alsode-pegged and collapsed in value. It seemed to some almost as if some immense and malignforce was at work, triggering currency crises and devaluations and in the process setting thesecountries back years if not decades in terms of economic progress. Just to bring this bookup-to-date, in February of 2001, the Turkish lira experienced the same fate, de-pegging againstthe US dollar from 600,000 and falling to a low of around 1.65 million in October of that year.It is without doubt that these experiences over the last 10 years have coloured our judgementand opinion on the subject of currency speculation. It would be difficult for that not to happen.The aim here, in this chapter, is therefore to attempt a difficult task, namely that of looking atthe issue of currency speculation from a fair and unbiased perspective. At the offset, I must sayif it is not already clear, that as a currency strategist in a global investment bank I am obviously(to a limited extent!) a participant in the currency market. My own experience should also betaken into account. That said, I am no more biased than anyone in the official community onthis issue. They have their (biased) perspective, a currency strategist has his/her own. MoreoverI have considerably more experience of seeing currency speculation than many, certainly mostwithin the official community. With that in mind, the aim here is neither to see currencyspeculation as a benign or as a malign force. Rather, it is first to draw the fangs of emotion andmorality from the debate and then to seek a balanced, unemotional and practical perspectiveof this issue of currency speculation. The very first thing one has to do in this regard is to seeksome sort of definition for what one is talking about. There are probably as many definitionsof this issue as there are people on the planet, however clearly that is not helpful. The broaddefinition I have used so far in the book is the following:Currency speculation is the trading in currencies with no underlying attached assetThis is of course far from a perfect definition. However, any weakness of this definition doesnot detract from our essential need to have a definition in order to put this whole debate – andindeed this chapter – in context. This is clearly not the only kind of currency speculation, butit is a useful reference, not least for the incentive of a currency speculator. Their main aim has
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nothing to do with an underlying, attached asset such as an equity or fixed income product.Their aim is purely to achieve what academic text books suggest is impossible – consistentexcess returns from currency directional trading.
9.2 SIZE MATTERSSo armed with this definition, however inadequate, let us now look at the issue of currencyspeculation in more depth. The second aspect of currency speculation to realize is its size. Onthe face of it, it is immense. The global currency markets turn over some USD1.2 trillion indaily volume, according to the 2001 report by the Bank of International Settlements. That isthe rough equivalent of world trade in global goods and services every day. In the last twodecades, as barriers to capital have broken down and capital markets become liberalized, inline with the move to liberalize trade in goods and services, capital flows have played anincreasingly important role in global currency markets. By comparison, world trade has seenits role diminish proportionally as a determining factor in exchange rate movement. Trying towork out the percentages of global currency volume is very far from an exact science giventhat one is faced with issues such as double counting and so forth. Nevertheless, it is possibleto get a rough idea of the relative flow importance of the different sectors of the market. Puttogether, and being generous rather than conservative in one’s estimation, world trade andinvestment (portfolio and direct) makes up around 30% of currency market volume. The rest,using our definition, is currency speculation, with no underlying asset behind it. I have not theslightest doubt that these figures will cause debate, if not outright rejection. The truth howeveris that I have been charitable and generous with the first half of the equation, that of tradeand investment. The imbalance in favour of currency speculation should actually not be thatsurprising. If one thinks about it, the economic textbook definition of a currency speculator asa liquidity provider to the productive areas of the economy might suggest an eventual 50/50role between the two sides. The liberalization and deregulation process seen over the last threedecades has meant that we have gone far beyond that.
9.3 MYTHS AND REALITIESOn the face of it, this may seem only to confirm the worst fears of those who see currencyspeculation as an intrinsically malign force, ready to bring down currency systems and governments on a whim. Surely, if currency speculation is such a dominating force within theglobal currency markets, then it is currency speculation that is responsible for currency crises.Following on with this logic, some may take the view that action should be taken to ensurethat currency speculation cannot cause such devastation and damage again! On the face of it,these are understandable conclusions. However, just because they are understandable does notmake them right. Indeed, I would suggest that they are at best overly simplistic and at worstflatly wrong for the following reasons:
r Currency speculation does not act or take place in a vacuum. Rather it is a response tochanges in fundamental or technical dynamics.
r The essential aim of currency speculation is not to bring down governments, or to hurtcountries economically, or for that matter to break currency pegs. Simply put, the aim is tomake money, pure and simple.r Currency speculation therefore is neither benign nor malign. Both of these terms haveemotional if not moral connotations. Currency speculation is amoral. It aims to make money,
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whether buying or selling a currency, and it will do that in direct and proportional responseto government economic policy.r In cases such as currency crises where substantial destruction is caused, currency speculation is the symptom rather than the underlying disease. Indeed, in the case of the UK in1992, currency speculation was the cure to the disease, which was a ridiculously overvaluedexchange rate value of sterling within the ERM.r Currency speculation does indeed provide a valuable service, in giving liquidity to theproductive areas of the economy.r The idea that a speculator is a seller and an investor is a buyer is worse than nonsense. It ispropaganda designed to cover policy mistakes.r In line with this, there are many more kinds of speculation than just currency speculation.Was not the NASDAQ bubble of 1999–2000 speculation? When Alan Greenspan dared totry to temper that irrational exuberance did he not get shouted down by the public and bycongress?This chapter is for both those who seek a clearer understanding of currency speculation,why and how it takes place, and also for the currency speculators themselves. The latter is donewith some humility for there are currency speculators who are amongst the most revered andrespected – and honourable – participants within the currency markets. In my career, I havemet many of these and many are amongst the most brilliant minds out there. Thus it is withcare that I have the temerity to suggest that some of these still have a few things to learn aboutthe currency markets! That said, another perspective is always useful. I have certainly foundthat myself. My experience is as someone who has followed the currency markets for the lastdecade, first as a journalist, then as an analyst, then as a manager of a currency business andfinally as a currency strategist for an investment bank. Perspective is important and being ableto look at an issue from several different angles sometimes critical. Thus, I hope I can say that Ihave gained immeasurably from the wisdom of my economist colleagues. We look at the samequestion from two completely different perspectives. Equally, it is my hope that even some ofthe most experienced currency speculators may gain from my no doubt different perspective.
9.4 THE SPECULATORS – WHO THEY AREMuch has been written about currency speculators in the past, much of it with a few rareexceptions utter nonsense. As noted above, the very term “speculator” can create an emotionalreaction. Here, in this section, we seek a dispassionate analysis of just who are the currencyspeculators, how and why they operate and their function within the overall currency market.The benchmark for this analysis is obviously the definition of currency speculation givenearlier; that is someone who trades in currencies without an underlying, attached asset. Tradeand investment do not count because of necessity they have attached, underlying assets. Whatis left – the vast majority – in currency market volume is speculation. So who takes part in thisactivity? Broadly speaking, currency speculators can be divided into the following main groups.9.4.1 Interbank DealersThis group makes up the vast majority of currency speculation and therefore of the currencymarket as a whole. The primary task of an interbank dealer is to provide liquidity and makemarkets in currencies for the bank’s clients. The principle is that all client positions have
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to be offset in the market (i.e. if a client sells you Euros against dollars, you the dealer arebuying the Euros and therefore have to sell those Euros back to the market to keep a flatexposure). In theory, the profit you make is the difference between your bid and the market’soffer. In practice, as bid–offer spreads have narrowed substantially, there has been a generalshift within the currency markets towards keeping some exposures one gains or loses fromclients in order to take speculative positions in the market to support the P&L of the dealingdesk. In addition, a dealing desk can use the bank’s balance sheet to take speculative positionsirrespective of client flow. Thus, while the reduction in bid–offer spread has reflected greatlyincreased information transparency and competition in the market, it has also resulted in amove to increase the “position taking” of an interbank or liquidity dealing desk. Such positiontaking may be more profitable, and there is no question that it is when a highly experiencedand professional chief dealer is in charge. However, this move has also undoubtedly addedto the volatility of the dealing desk’s P&L. Equally, it may also have added to overall marketvolatility.This may seem a contradiction, as narrower spreads should be a reflection of greater volumeand liquidity. However, the reality is that as those spreads have narrowed, so position taking hasincreased. Larger positions are taken on by interbank dealing desks in order to maintain or boostP&L, and therefore as a result larger positions have to be unwound during periods of adverseprice action. Equally, those narrow spreads can be an ill