from the experience.
About the AuthorCallum Henderson is Head of FX Strategy for a leading international bank, based in Singapore.A widely quoted authority on both emerging and currency markets, Mr Henderson has spentthe past 16 years in the financial markets in various capacities and has written articles for manyleading financial journals and given seminars around the world on global currency markets.Mr Henderson is the author of three previous books covering the Asian economic story, thebestseller Asia Falling: Making Sense of the Asian Currency Crisis and its Aftermath, Chinaon the Brink: The Myths and Realities of the World’s Largest Market (awarded Best BusinessBook of 1999 by the Library Journal of the U.S.) and Asian Dawn: Reform, Restructuring andInvesting in the New Asia.Mr Henderson holds a B.A. Honours in Politics, Economics and French from SunderlandPolytechnic, a DEF III degree from L’Université de Tours and an M.A. in Middle East Politicsand Economics from the University of Exeter.The views expressed in this book are those of the author and do not necessarily reflect thoseof his employer.
IntroductionIt is the largest and most important financial market in the world. If you are in business or infinance, it affects just about everything you do, whether you like it or not, whether you know itor not. Along with the interest rate, it is the most important price of a free and open economy.It is the fuel of economic trade and liberalization and without it globalization would never havehappened. It is also one of the least well-understood markets outside of those who choose tofollow it in whatever capacity of their profession. It is variously described as the “currency” or“foreign exchange” or “FX” market, and it can be maddening and frustrating, but if you are asenior corporate officer or an institutional investor you are compelled to know what it is, howit works and how it affects you.It should be stated right at the beginning that this is a book targeted not at the ordinary manor woman on the street but at the currency market practitioners themselves, at those whose“flows” are responsible for moving the market in the first place. The aim of this book is a simpleone – to help currency market practitioners, from corporate Treasurers and Chief Executivesto hedge funds and “real money” managers, execute more prudent and profitable currencydecisions in their daily business.This is no small aim and it is certainly not taken lightly. There is of course already a richliterature on the subject of exchange rates, as many readers will no doubt be aware. Whenyou took business courses or did an economics degree at whatever level you probably had towade your way through several of these. Why then the need for yet another book on exchangerates? The frank answer is that I felt there was a gaping hole in that “rich” literature, a massiveomission that was intolerable and had to be addressed. Simply put, few if any of these worksappeared to be aimed at the actual people who would have to put the theory into practice andactually execute the currency market transaction. It was as if a bank had written a series ofbooks not for its clients or customers but instead for its own private, intellectual interest. Thevast majority of the existing literature on exchange rates appeared to have been written froma very academic or theoretical perspective. To be sure, there are notable exceptions and inany case there is absolutely nothing wrong with academic theory. Few of these however wentthe extra mile and explained how to translate the theory into currency investing or hedgingstrategies. My aim here therefore is to address this “gaping hole” and try and do a better job ofexplaining both currency market theory and practice from the perspective of being a marketparticipant myself, albeit in an advisory capacity.The currency market is not just my job. It is a passion and interest of mine and has been so formany years now. I started covering it in 1991 as a journalist in the run up to the Sterling crisis
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the subsequent year and “Black Wednesday”, September 16, 1992, when the UK currency wasforced out of the Exchange Rate Mechanism (ERM) and promptly collapsed in value. Theabiding memory of mine to this day is of the sheer power of the currency market in its ability to“defeat” the might and resolve of such a respected central bank as the Bank of England, whichgave everything it had in its effort to defend sterling’s ERM “floor” against the Deutschmarkof 2.7778. It is a memory of currency dealers screaming down the phone, of wave after waveof official intervention to support sterling being swatted aside by the sheer weight of sellingpressure. The lesson of this neither is nor should be that financial markets will out in all cases.Rather, it is that the currency market has become so huge that it simply cannot be resistedfor any length of time. In the case of “Black Wednesday” – or “White Wednesday” as manywould have it subsequently – the UK economy was experiencing a severe recession and thussimply could not tolerate the raising of UK interest rates needed to support sterling and keepit within its ERM band commitment. The economic pain of this interest rate and exchangerate commitment was completely at odds with the economic reality in the UK at that time.Moreover, UK foreign exchange reserves were fast being wiped out in that defensive effort.In 1992, the global currency market’s daily turnover was the equivalent of USD880 billion,according to the Bank of International Settlements (BIS) tri-annual survey. Thus, the Bank ofEngland’s ability to intervene to support sterling, albeit in the billions, was dwarfed by thesize of the forces opposing it. As of the 1998 BIS survey, daily turnover had increased to someUSD1.5 trillion, subsequently falling back to USD1.2 trillion in the 2001 survey in the wakeof the creation of the Euro.Needless to say, the Bank of England has certainly not been alone in its inability to defeatthe power of the currency market. The following year, the remaining members of the ERMwere forced under truly extraordinary pressure to abandon the narrow 2.25% bands required bythe ERM commitment, widening them to 15%. On one day alone, on that Friday, July 30, beforethe weekend move to capitulate and widen the ERM bands, tens of billions of dollar equivalentwere expended in an ultimately futile attempt to support member currencies. Depending onyour point of view, even the feared German central bank, the Deutsche Bundesbank had beendefeated (though the sceptical maintain that its effort to save the ERM was at best half-hearted).Whatever the case, it was an important lesson; not least that the currency market can act withunparalleled force and ferocity if it is so impelled. There was of course the obvious question –why and how could such extraordinary events happen in the currency market, events that werecertainly not predicted by economists and which sometimes did not appear justified by the“fundamentals”?For me, as for many people in the field, that time was the start of a journey, a journey I suspectwithout an ultimate destination. One remains forever a student and the capacity for being takenby surprise remains endless. As a Head of FX strategy for a leading international bank, thelosses that one can incur as a result of making forecasting or recommendation mistakes arenot so much financial as reputational, but for that I would argue they are no less painful. Asa member of that relatively small group of individuals who for good or ill seek to forecastexchange rates and make currency recommendations, you live or die by your reputation. Youdo not have the luxury of resorting to vague rhetoric and that is indeed how it should be.Nonetheless, as anyone who has tried knows, forecasting exchange rates is both an educational and a humbling business. A factor that is deemed a crucial market driver one minute maybe spurned the next as irrelevant. Most attempts within economic “fundamental” analysis toanalyse exchange rates are based on some form of equilibrium model, which presupposes thatthere is an ideal or an equilibrium level to which exchange rates will revert. While equilibrium
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3
exchange rate models such as those that focus on Purchasing Power Parity (PPP), the monetary and portfolio approaches, and the external balance, real interest rate differentials and theReal Effective Exchange Rate (REER), are extremely useful when trying to predict long-termexchange rate trends, most have a relatively poor track record over a shorter time frame.They provide a framework for currency forecasting and analysis and alert the users of themto important changes in the real economy and how those in turn might affect exchange ratesover the medium to long term. For instance, economists would say that an appreciation of acurrency’s REER value should eventually cause deterioration in a country’s external balance,which should lead to a loss of export competitiveness and the eventual need for a REER depreciation of the exchange rate in order to offset that lost competitiveness. The most effectiveway of achieving this is through a depreciation of the nominal exchange rate (as in the one youuse when you take a trip to France). For a corporate this may be an invaluable guide as to thelong-term exchange rate trend, which they can use to determine the parameters of their budgetrates and also to set a strategic hedging policy. What this does not do however is tell the userwhen these events are likely to happen. It can provide a framework, a corridor, but it is unableto be more specific. In short, such models are limited in their ability to forecast exchange ratesover the period on which most currency market practitioners are focused – 1 day to 3 months.The economics profession usually deals with this inconvenience in one of two ways – eitherby ignoring it or by dismissing short-term currency moves as “speculative” and therefore notcapable of being predicted. It has long been my view that such a response was inadequate andthat in order to study currency markets one might therefore have to include other disciplines,albeit within a single analytical framework. Indeed, where economics has for the most partfailed to predict such short-term moves, other disciplines such as technical and capital flowanalysis have succeeded. Granted, their success is not perfect, but it has been measurably better.Furthermore, while it has to be stressed that such long-term valuation models are importantand useful guides to long-term trends, they are flawed as forecasting tools because the veryconcept of “equilibrium” is itself flawed. Such a concept is a useful and logical construct,providing a framework around which economic analysis can be built and allowing one to focuson a final outcome. The specifics of that final outcome are likely to remain vague however.While an equilibrium model may be able to tell what the final outcome is likely to be, it will notbe able to tell you when that outcome will happen nor what might happen in the getting there,which might change or distort that outcome. Moreover, while the construct of equilibriummay well be close to academic hearts, it seems rarely evident in real life, which remains in aconstant state of flux. An equilibrium level relates to a point to which exchange rates, if theyare temporarily divergent from it, will revert back. In other words, it relates to an ultimatedestination, or a “final outcome” as described above. Markets however are volatile and canfluctuate widely. Yet markets are an expression of economic reality, which means that theeconomic reality itself fluctuates. In turn, this means that the equilibrium level resulting fromthat economic reality also fluctuates and instead of being a stationary, single, final outcome israther a moving target. In economic jargon, the equilibrium level of an exchange rate is bothcause and effect of the present level of exchange rates, moving over time, such movementconstantly reducing or increasing the present exchange rate’s over- or undervaluation relativeto that equilibrium. This is not to say that trying to track an equilibrium exchange rate level isnot an important exercise. Rather, it is to point out the practical limitations of such equilibriumbased exchange rate models.As well as examining the limitations of exchange rate models, it is also important to dispose right at the start with a few myths that surround financial markets in general and more
4
Introduction
specifically the subject of this book, the currency market. Firstly, classical economic theoryasserts that market practitioners are “objective”, that is they are completely independent of andare not affected by the market conditions in which they operate. Intuitively, we know this to benonsense. An investor is not only directly affected by present market conditions such as liquidity and volatility but also by past experience. Past successes may make our investor bolderin their future investment decisions, while past losses may make them much more cautious. AsJohn Donne would have it, no man is an island, so the same is true for the market practitioner,who can both be affected by and can affect market conditions. In short, they are both cause andeffect. We can see this with that most fundamental of economic principles, supply and demand.Here too, there is no “objectivity”. Each is affected by the other – and we know this becauseif it were not the case price trends could not happen. If they were completely independent ofeach other, supply would instantly match demand and vice versa, thus stopping a price trendbefore it had begun. Yet, this is not the case. Price trends across asset and currency marketscan last for days, weeks, months or even years.Another widely held myth is that markets are perfectly “efficient”. The suggestion here isthat both information availability and distribution are perfect – that all market participantshave equal access to available, market-moving information. Furthermore, the assumption ofmarket efficiency is that all market participants are “rational” and are profit seeking. Like thesuggestion of “objectivity”, this is also the stuff of nonsense. Information is widely and freelyavailable, but neither its availability nor its distribution is perfect. Indeed, one could argue thatthe very purpose of currency market practitioners is to get information that others do not have.Equally, the very concept of being “rational” is a subjective one and open to interpretation.Further, currency dealers are “rational” to the extent that they are trying to make a profit.However, cautious investors or corporate Treasurers who are seeking to manage their currencyrisk are not trying to make a profit. Rather, they are trying to limit any possible loss fromtheir original currency exposure. Central banks and Treasury departments, who also operatewithin the currency market, are also not for the most part profit seeking. Trying to impose anall-fits-one approach to explaining exchange rates simply does not work. For this very reason,economics by itself has had mixed results at best in forecasting exchange rates. The dynamicsof the currency market are different from other markets and this should be taken into account.As we have seen, equilibrium exchange rate models help to provide the framework andthe direction for long-term exchange rate analysis, but they are for the most part incapable ofbeing more specific or more accurate over a shorter time frame. In trying to forecast shortterm exchange rate moves, it may be necessary to use other tools and even other analyticaldisciplines. Within this book, there are outside of economics four types of analysis that wewill look at for this purpose: flow, technical, risk appetite and market psychology. Dependingon what kind of currency market practitioner you are, you may view one or more of theseanalytical disciplines with some scepticism. This is all to the good, for if someone is to use anyform of analysis in their daily business they first have to be convinced that it actually works.We will examine these types of analysis in detail in the first four chapters of this book. Forinstance, market psychology may be thought of as an excessively vague concept incapable ofserious analysis or use, yet this is precisely what the field of “behavioural finance” seeks toexplain. How else to explain the fact that political events that do not materially affect economicfundamentals can have lasting impact on exchange rates, were it not for the fact that such eventschanged the “psychology” or “sentiment” of the market? In early 1993, the then US TreasurySecretary Lloyd Bentsen was reported as saying that the Japanese yen was undervalued. Thisstatement and others after it led the market to believe that the US was deliberately seeking to
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5
devalue the US dollar against the yen in order to reduce the huge US–Japan trade deficit.Whatever the reality, the market convinced itself that this was the case and for two years afterthat statement the yen rose inexorably against the US dollar. Did economic “fundamentals”play a part? Of course they did. Japan’s huge trade and current account surpluses with the USmeant that for the dollar–yen exchange rate to remain stable Japan had to export to the USthe same amount of capital through its capital account deficit. At times when this was not thecase, the yen was bound to appreciate and so it transpired. The trigger, the catalyst for thissubsequent yen appreciation was however a change in market sentiment or psychology – and ittook another change in market sentiment resulting from the new US Treasury Secretary RobertRubin’s call for an orderly reversal of the dollar weakness for that yen appreciation to reverse.The subject of technical analysis also draws mixed reactions. While widely followed bycurrency dealers and the leveraged fund community, many corporate officers and investorsappear to regard it with scepticism – and many economists look on it as some form of voodoo orwitchcraft. Yet technical analysis or “charting” has a strong following not for any ideologicalreason, but simply because it “works”. Like any other form of analysis, there are technicalanalysts who are highly regarded by the market for their accuracy in meeting their forecasts,and those that are less successful. The appealing thing however for many market practitioners isthat technical analysis has targets at all. While there are important exceptions, too many withinthe economics profession remain content to talk eloquently if vaguely, attaching a multitudeof caveats and in sum coming to no conclusion whatsoever. Needless to say, decisions onwhether or not to hedge or invest cannot tolerate such imprecision. Where the strength ofequilibrium exchange rate models is in providing a long-term exchange rate view, the strengthof technical analysis is in predicting the timing of currency moves. In particular, it can beespecially effective in predicting when those fundamentally-based long-term trends may takeplace.A more recent addition, at least in its present form, to this group of short-term analyticaldisciplines is “flow” analysis, which involves the tracking of a bank’s client flows, again forthe purpose of forecasting short-term exchange rate moves. One of the most well-known flowanalysis products within the industry is CitiFX Flows. The field of behavioural finance hasundertaken considerable research into behavioural patterns such as investor herding, whichcan both be responsible for accelerating short-term trends and also for reversing them. Thebroad rule of such trends is that the longer they continue the more they become self-fulfilling.This is of course how financial bubbles develop, in whatever kind of market. As the old adagegoes, when you find your taxi driver giving you stock tips, it’s probably time to get out of themarket! We shall look at this recent yet intriguing discipline of flow analysis later in the book.Most works to date on exchange rates rely purely on “fundamental” analysis, falling back onthe traditional exchange rate models. While several of these are notable, most would appear tocome up short on two grounds. Firstly, they fail to address the issue of the forecasting inaccuracyof those models. Secondly, few have included other analytical disciplines to try to improve onthat forecasting inaccuracy. Crucially, few have tried to see exchange rates from the perspectiveof the end user of analysis or the currency market practitioner. For those who trade, invest orhedge in the currency market, the bottom line is indeed the bottom line. Fundamental economicanalysis is the means, but it is not the end. A key aim of this book is to include other analyticaldisciplines and also to use a more currency-focused form of economic analysis or as I termit “currency economics”, both for the purpose of trying to improve currency forecasting andrecommendation accuracy. Using these various disciplines, I would recommend that currencymarket practitioners adopt an integrated approach towards currency forecasting and strategy
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Introduction
that is both rigorous and flexible. Equilibrium exchange rate models should still be used asthe guide for short-term exchange rate trends, but for short-term moves a combination ofcurrency economics, flows, technical analysis, risk appetite and market psychology should beused. Therefore, at its most ambitious this book, Currency Strategy: The Practitioner’s Guideto Currency Investing, Hedging and Forecasting seeks to provide a new and more focusedframework for currency analysis and thereafter to apply it to the decision-making process ofthe currency market practitioner themselves.The fact that the currency market affects just about every aspect of our economic life is arelatively recent phenomenon. Before 1971–1973, when the Bretton Woods system of peggedexchange rates, which had lasted since 1944, finally collapsed, you would have been laughedat if you had suggested as much. Currency risk was not a primary consideration. Indeed, thelast 30 years have marked the first time in monetary history that all major currencies have beenfreely floating and completely independent of some commodity peg. You could say as a resultthat we are living in a time of monetary experiment, an experiment that remains the subject ofgreat controversy and debate as to whether or not it has been beneficial or harmful. For my part,I nail my colours to the mast from the outset. I am an unequivocal, unashamed proponent offree trade and free capital markets. There is little doubt that free and open competition carrieswith it a harsh discipline. Yet, just as there are flaws with that other experiment, democracy, soit can be measured only on a relative basis; that is, it is the worst option, apart from all the rest.Attempts at subsidizing the economy have clearly failed, thus for now free trade and capitalmarkets reign supreme until such time as better alternatives come along. The currency marketsare the fuel within the engine of globalization, an experiment that provides the liquidity forthe world’s markets.That experiment began more precisely on August 15, 1971 when US President Richard Nixonannounced that the US was abandoning its convertibility commitment between the value of theUS dollar and gold at the rate of USD35 per ounce of gold. A diplomatic band-aid was subsequently attempted in December 1971 in the form of the so-called “Smithsonian Agreement”,but the attempt to keep major exchange rates pegged and shackled finally collapsed in March1973. As with the ERM crises of 1992 and 1993, the cost of defending a currency peg thatwas incapable of responding to economic changes was eventually viewed as intolerable. The1971–1973 period was unquestionably the seminal turning point in the development of thecurrency markets. Subsequently, there were historical events of varying importance, not leastthe development of the European Monetary System or the “Snake” which was succeeded bythe ERM, the various oil crises, the Plaza and Louvre Accords of 1985 and 1987 respectively,and the coordinated G7 effort to achieve an “orderly reversal” of dollar weakness from 1995onwards. None of these however carried the same weight as that of the second most importantevent in the recent life of the currency markets, the break-up of the Soviet Union and theending of the Cold War. The coming to power in the Soviet Union of Mikhail Gorbachev in1985 was a momentous event, the effects of which are arguably still being felt to this day.Glasnost and perestroika were primarily viewed as political doctrines of change, but they alsoreflected significant economic change and not just for the Soviet Union.The tearing down of the Berlin Wall and the ending of the Soviet occupation of EasternEurope marked the end of an era of hostility, conflict and subjugation, but it also marked thebeginning of the tearing down of global trade and capital barriers. The competition of the futurewould not be with arms, but instead with trade and economic competitiveness. This most recentphase of globalization is widely thought of as only being three or four years old, but it datesfurther back to those heady days of hope in the late 1980s, when all things seemed possible
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7
and the prospect of “mutually assured destruction” through nuclear confrontation between theUS and the Soviet Union was ended. Purists will argue that there have been previous examplesof globalization, notably around the beginning of the twentieth century, an experiment that aswe all know ended badly, but for our purposes we focus only on this more recent exercise.The breaking down of those barriers – firstly those made of brick and subsequently thoseeconomic barriers to free markets – triggered an explosion in trade and capital flows, which inturn triggered a parallel explosion in the size of the currency market as the BIS surveys from1989 to 2001 confirm. At a daily turnover of around USD1.2 trillion a day, the currency marketnow dwarfs the US stock or bond markets. As the pulling down of trade and capital barriershas led to investors and corporations seeking to expand and diversify in other countries, sothe global currency market has been the facilitator of that, and in the process increased in sizeexponentially.When the experiment began in late 1971, most economists viewed favourably this newfoundexchange rate flexibility. Subsequently, to some, the experiment that started 30 years agoappears to have created a monster. The last decade in particular has seen much talk of a need tobring exchange rates back under control, either through a tax on currency trading (the so-called“Tobin Tax” idea) or a move to re-peg exchange rates, perhaps even using gold as the monetaryanchor. From my perspective, while exchange rate volatility is frequently unwanted, empiricalstudies have noted that over the long term it is lower than equity market volatility and few aretrying to shackle similarly the equity markets. Equally, the explosion the world has seen intrade, finance and most of all growth simply would not have taken place were it not for thecurrency market, acting as the facilitator of that growth.Whatever one’s view on the matter, there is no debate as to the global effect the currencymarket now has, nor that currency risk is now a crucial consideration. At the level of theordinary man or woman on the street, the most obvious expression of this is through travel.When travelling abroad, most people consciously or subconsciously translate “foreign” pricesback into their home currency terms to give them a frame of reference. Thus, the price of foreigngoods can seem “cheap” or “expensive” relative to the price of the same good in the homecountry. Economic models can be more effectively explained sometimes through exampleand analogy rather than through complex mathematical formulae. For instance, Americansgenerally regard the UK as “expensive”. If a New Yorker, who is used to paying a dollar fiftyfor his morning cappuccino comes to London and has to pay three pounds sterling (USD4.5at a sterling–dollar exchange rate of 1.5) the UK price is clearly expensive. In our example,the price differential reflects the sterling–dollar exchange rate, the relative supply/demanddynamics of cappuccino in New York and London and the different cost prices. The “law ofone price” otherwise known as Purchasing Power Parity suggests that over time the exchangerate between two countries must alter so as to correct any imbalance between the price of thesame basket of goods in those two countries. In our cappuccino example, if we use a cup ofcoffee as reflective of the general price differential for a representative basket of goods betweenthe US and the UK, a combination of a sterling depreciation over time against the dollar anda fall in the domestic London price of cappuccino relative to that in New York should occurin order to narrow the price differential. In theory, this works fine over the long term. Readerswill note that in 1992, the sterling–dollar exchange rate was briefly above 2.00. At the start of2002, it was around 1.45. Over the short term, however, the record of PPP is decidedly morepatchy, which is of course no consolation to London coffee lovers or to our New Yorker guest!Relative pricing can be further distorted by other factors such as barriers to trade and differentcultural tastes. For instance, some people may not like coffee while to others it may be against
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Introduction
their religion. That said, it holds true that the exchange rate is a key determining factor for howone defines “expensive” or “cheap” in the first place.The same premise is also evident at the corporate level. When the US dollar was appreciatingto multi-year highs against European currencies during the period of 1999–2001, this togetherwith the fact of strong US consumer demand made it very attractive for European manufacturersto export their production to the US at increasingly competitive prices. The strength of the UScurrency deflated the dollar price of these products, thus making them more competitive andencouraging US consumers to buy more European goods. For US exporters, however, thepicture was the opposite, as their exports to Europe became less competitive as the dollarstrengthened, reducing their market share or pricing them out of some markets entirely. Thus,the US trade deficit ballooned, not just with Europe, but with the world as a whole, reachinga level of some USD400 billion in 2001. Yet, just as the US trade deficit was expanding,so more competitive exports to the US together with a slowdown in US demand in 2001forced US manufacturers in turn to cut their prices, reducing inflationary pressures. However,as corporate executives are painfully aware, just as domestic currency weakness can lead tomore competitive exports and thus higher profits, causing a benign circle, so a vicious circlecan result from domestic currency strength, hurting one’s export competitiveness. From theperspective of a European exporter, a weak dollar is not a good thing, as it causes the exporter’sprices to rise in dollar terms. At some stage, those higher prices will cause US consumers tobuy American instead of European. This will cause the US trade deficit with Europe to shrink,but it will also bite hard into the profits of European exporters.Exporters are of necessity keenly aware of the importance of exchange rate movements.However, companies that have no exports but simply produce and sell in a single country arealso affected. A company that has no direct export exposure and thus thinks itself blissfullyexempt from currency risk is in for a nasty shock. As we have seen in the above example,changes in the exchange rate – the external price – cause changes in turn in the domestic priceof goods and services. Thus, if your currency strengthens against that of your competition,you face a competitive threat – and assuming all else is equal, the choice of either cutting yourprices, thus reducing your margin, or losing market share.Currency movements can also have a profound effect on investing. Fixed income and equityportfolio managers, in investing in another country’s assets, automatically take on currencyexposure to that country. Frequently, fund managers view the initial decision to invest ina country as being one and the same with investing in that country’s currency. This is notnecessarily the case for the simple reason that the dynamics that operate within the currencymarket are frequently not the same as those that govern asset markets. It is entirely possible for acountry’s fixed income and equity markets to perform strongly over time, while simultaneouslyits currency depreciates. My favourite example of this phenomenon is that of South Africa.From the autumn of 1998, when the 5-year South African government bond yield brieflyexceeded 21%, this was one of the world’s most outstanding investments until November2001. By then, this yield had made a low of around 9.25%, a direct and inverse reflection of thedegree to which its price soared over the previous three years. In that time however, the valueof the South African rand has fallen substantially from around 6 to the US dollar to almost 14.Here is a clear example where the currency and the bond market of the same country were goingin opposite directions over a period of three years! An investor in the 5-year South Africangovernment bond in the autumn of 1998 would have seen their excellent gains in the underlyingfixed income position over that time wiped out by the losses on the rand exposure. The lessonfrom this is that currency risk should be an important consideration for asset managers and
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9
moreover one that is managed separately and independently from the underlying. Empiricalstudies have shown that currency volatility reflects between 70 and 90% of a fixed incomeportfolio’s total return. Thus, for the more conservative fund managers, who cannot take suchswings in returns but do not take the prudent step of hedging currency risk, it can be the mainreason why they stay out of otherwise profitable markets. Conversely, currency risk can alsoenhance the total return of a portfolio. When the US dollar was falling from 1993 to 1995,this made offshore investments more attractive for US fund managers when translating backinto dollars. It was no coincidence that this period also saw a substantial increase in portfoliodiversification abroad by this investment community.There is little doubt that currency exposure can be unpredictable, frustrating and infuriating,but it is not something one has the luxury of ignoring. In John Maynard Keynes’ refer