Foreign Exchange: An Overlooked Asset Class?

Owing to ongoing globalisation, the financial markets have become increasingly efficient and homogenous over the past few decades. The resulting increased interdependence between the traditional markets impedes the quest of investors for assets that offer an attractive return potential with simultaneous low correlation to their portfolio. This has prompted a rise in interest in alternative asset classes such as hedge funds and commodities. Hence, although substantial risk-adjusted returns can be achieved on the foreign exchange (FX) markets and despite the outstanding diversification opportunities available here, this asset class has long been overlooked by investors. In recent years, however, this tendency has reversed and investors have begun to increasingly consider the opportunities offered by FX for tapping into new sources of returns by means of active management.

At first glance it may seem hard to understand why one currency should appreciate or depreciate against another. Many investors find it strange that there are no bear or bull markets in the world of FX. If one currency increases in value, by definition the value of another must fall. In particular, short-term movements caused by surprising macroeconomic or geopolitical news, together with short-term and medium-term irrational behavior, cause confusion and give rise to the impression that foreign currencies are speculative and volatile. However, investors who acquire a clear picture of the FX markets can tap new opportunities for generating returns and substantially optimize their portfolios.

An Efficient Market?

At first sight, the FX market contains most of the characteristics of an efficient market. It is by far the largest and most liquid market in the world. An estimated US$2 trillion is traded via this market every day. This is the equivalent of 50 times the daily trading volume of the New York Stock Exchange. With trading taking place around the globe 24 hours a day, six days a week, the FX market has the longest trading hours and is geographically broadly dispersed. A particularly impressive consideration is that this huge market is still growing rapidly. Globalisation – supporting international activities – and the ongoing development of electronic trading are important drivers leading to growth in the market volume. The low transaction costs involved in entering and exiting an FX position also contribute to market efficiency. As the bid-ask spreads are extremely low, market participants can realise profits instantaneously. For example, under normal conditions the €/US$ exchange rate has a spread of one to two pips in the interbank market. The large number and variety of market participants is a further element that makes the FX market unique. International corporations, central and commercial banks, as well as private and institutional investors such as fund managers and hedge funds are the most commonly mentioned players. Whether we are aware of it or not, each of us participates in this market at one stage or another, for example by traveling abroad, by purchasing a German car brand that may have been manufactured in Eastern Europe, by investing in foreign securities, or simply by virtue of the fact that our pension fund actively manages foreign currencies. This is probably attributable to the fact that, in most cases, the market features little to no entry barrier for participants.

However, most market participants are acting irrationally by playing a passive role in the currency market and seeking goals other than pure profit maximisation. For instance, multinational companies tend to get involved in the FX markets primarily for liquidity or hedging purposes. This offers profit-seekers the chance to exploit the resulting inefficiencies and thus generate attractive risk-adjusted returns. The fundamental sources of return in the FX markets can be summarised in terms of three main categories: valuation, carry and technical. The first two categories are described below.

Mirror of Economic Fitness

As a general rule, a currency can be viewed as the mirror to a country’s macroeconomic and political development. Economic growth, price levels, the productivity of a country and its interest-rate level are all decisive factors that influence the value of a currency. Other factors that also need to be taken into account include the interest-rate difference compared to other countries, the purchasing power of a currency, a country’s balance of payments, and international investment flows. As with equities, valuation models can be used to ascertain whether or not a currency is being traded at its ‘fair’ exchange rate. As a consequence of participants’ irrationality, currencies may temporarily deviate from their fair value as dictated by economic parameters. In the long term, however, such situations cannot last and currencies then tend to return toward their fair values. Investors can exploit these FX fluctuations by purchasing currencies that are undervalued and selling the ones that are overvalued.

The most simple valuation model is the purchasing power parity (PPP). However, several studies have shown that, although this model can be used in the longer term to explain some exchange rate fluctuations, it does not capture all them. Most banks have therefore developed their own valuation models. These are econometric models that serve to extend the PPP in line with factors such as productivity, the bond yield level and external balances. They are used on a regular basis by fund managers and analysts to make forecasts as well as recommendations regarding the development of exchange rates.

Skillful Exploitation of Rate Differential

A further opportunity offered by the FX markets is the inefficiency linked to global interest rate differences. It is widely understood that interest rates can differ significantly between countries. While a 12-month money market investment in Switzerland will earn interest of around 3%, investors in Brazil can expect interest of up to 10.75% over the same period. Various empirical studies have shown that, over longer periods, foreign exchange moves are, on average, not large enough to erode the interest rate advantage between countries and even tend to support it – a phenomenon known as forward bias. For investors this means that sustainable returns, which are even comparable to stock market returns, can be achieved from interest rate differences. Carry strategies attempt to profit from this inefficiency by investing in high yielding currencies and borrowing in low yielding ones. Carry strategies can appear to inexperienced investors to be free money, whereby they simply cash in the interest rate differential. However, investors need to be selective and to bear in mind the risks linked to simple carry trades such as those entailed by individual currencies, time-varying volatility, and systemic risks. Timing and risk management are key to the success of such strategies. Even if the risks linked to simple carry trades cannot be eradicated, they can be greatly minimised. This has led some leading banks to develop innovative investment solutions offering investors the opportunity to benefit from global interest rate differences within the framework of a diversified and optimised investment model. The portfolio strategy takes account of changing interest rates and risk parameters by reviewing and refreshing the portfolio allocation on a regular basis, such as once a month. Using sophisticated models, the currency weightings are calculated to optimise the relationship between the risk and the overall return of the investment by maximising the expected return for a given volatility target.

FX: An Attractive Portfolio Diversifier

Currencies perform in a way that is largely independent of the events in bond and equity markets and therefore offer an interesting form of diversification. The table below shows that the monthly returns of the US Dollar Index (DXY) – representing the FX market – were negatively correlated to other markets during the period from February 2000 to May 2007.

When FX investments are combined with a broadly diversified portfolio, this characteristic of foreign currencies is accordingly exploited: A better spread of individual portfolio positions is achieved, thereby reducing the overall risk – in keeping with the proverb of not putting all your eggs in one basket.

Suitable for Everybody

The FX market offers investors a broad range of flexible instruments to actively manage their FX exposure according to their specific needs. The currency derivative market with instruments such as forwards, swaps and options is the deepest, largest and most liquid market in the world. Structured derivatives, in particular, are increasingly popular among all types of investors – from beginners to hardened professionals. This is mainly due to the fact that structured derivatives are highly flexible and enable investors to benefit from the development of one or more currencies according to their own personal risk profile and goals.

Hedgers – Alongside classic hedge instruments such as forwards and options, a large range of tailor-made structured solutions offers hedgers a high degree of flexibility. In addition to portfolio or cash flow protection against FX risks, the hedger may have the opportunity to benefit from potentially favourable spot movements and enhanced hedging compared to forward transactions, or to reduce the upfront hedge cost compared with a hedge with options (‘zero cost’ strategies).

Investors and yield enhancers – In addition to purely return-oriented investment opportunities, investors can also opt for products with capital protection that safeguard their original capital even in the event of unfavorable market conditions. Depending on the type of investment, returns can be generated against a backdrop of rising, falling, or sideways-tending exchange rates. There is an almost unlimited range of potential underlying instruments. Ways of exploiting current market opportunities are therefore not difficult to find. And in addition to the possibilities offered by traditional currencies, new investment opportunities are also emerging in growth markets such as Asia and Latin America. Moreover, structured derivatives offer investors access to currencies that are not freely convertible, such as the Chinese Renminbi. Currency baskets that offer simultaneous exposure to a large number of different currencies with the purchase of a structured derivative are particularly popular. Thanks to the ever-greater liquidity, flexibility and innovative forces at work in the FX markets, there are almost no bounds to the creativity of financial engineers.