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The market with the FX factor

The foreign exchange market offers an excellent source of diversification where a huge range of participants can optimise their risk/reward profiles as they exploit currency divergences

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With daily traded volumes of some $5trn, the foreign exchange (FX) market offers investors an extremely broad, liquid and diversified asset class with which to generate alpha.

The FX market has expanded rapidly over the past two decades and is now the biggest financial market in the world. Alongside the development of the currency options markets, and other currency derivative products, the FX market’s huge growth in volumes and liquidity has been matched by increases in sophistication, transparency and market access. This behemoth market, traded around the clock during the business week, provides appreciable liquidity for investors who are increasingly anxious to have the means to manage their currency risk, especially during periods of considerable volatility.

Beyond the strictly passive management strategies, which involve hedging part of or the entire currency risk exposure inherent in international portfolios, currency hedging (or “overlay”) is increasingly being used in active management as an additional source of alpha creation.

But why is this happening? There are some obvious features that make the FX market an interesting asset class in multi strategy and multi asset investment management. In offering a broad, liquid and diversified investment universe, it can provide an effective source of statistical diversification and non-correlation and thereby be used to reduce the overall volatility of a portfolio.

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Additionally, it can be a source of alpha that is not cash consuming, though its main quality is the diversity of the underlying investments. The FX market attracts many participants with different investment motives and investment horizons. These include: central banks (which do not typically foresee a profit or return target but may intervene to influence the macroeconomy); traditional investment managers and hedge funds (which increasingly use this asset class as a source of alpha); commercial and merchant banks (which use FX markets to provide liquidity and manage the exposures of their clients and of their own balance sheets); pension funds (which directly hedge currency risks) and finally multi-national firms (which typically hedge balance sheets and commercial transactions or repatriate profits from abroad).

The diverse nature of these participants and their roles makes this market somewhat “inefficient” as conventionally defined by financial economic theory (at least over shorter term time horizons), and thus creates numerous opportunities for such divergences to be exploited as part of a discretionary or model-driven active management strategy.

The chart below highlights the non-correlation of foreign exchange rates with traditional investment returns as it plots the dollar index against a global aggregate bond index and a world equity index. The traditional negative correlation between the equity and bond indices is apparent but the dollar index has no significant interrelationship or correlation – as is the case across a broader sub-set of currencies in the long term. By implication, the returns on an FX strategy are equally non-correlated. Hence with the right currency manager and a strategy commensurate with the underlying portfolio risk and investment objectives, the FX market can offer both positive alpha and reduced overall portfolio volatility.

With a risk level arguably somewhere between bonds and equities, the currency market fits in perfectly with an absolute return strategy. This market can be traded to benefit investment themes simply and within strictly controlled risk budgets, owing to the correlation of certain exchange rates with global macro themes. For example, a portfolio could be exposed to commodities markets by trading currencies such as the Canadian dollar or the Norwegian krona (strongly correlated to oil) or for that matter the Australian dollar (strongly correlated to the Chinese economy and to base metal prices).

Similarly, the currencies of certain developing economies of Latin America such as the Mexican peso and Brazilian real could be used in carry trading strategies, given the growing weight of these countries in international trade with their associated higher interest rates. Furthermore, risk aversion indicators can be very usefully combined with different strategies to avoid the repercussions of a sudden sharp increase in underlying volatility. Conversely, short positions in emerging currencies could represent an effective hedge during risky asset deleveraging phases.

The evolution of dynamic and active currency management strategies makes it possible to exploit a broad variety of investment opportunities and themes. Therefore currency markets are an excellent source of diversification, enabling investors to optimise their risk reward profile while capturing another potential source of elusive alpha.

Over recent years the effects and implications of the financial crises have driven many assets to extreme levels of valuation – this has also been true of individual currencies within the FX market. Currently, as the global economy shows signs of recovery, these valuations will come under greater scrutiny and perhaps more significantly, as recovery is attained by different economies at different times and at different paces, the resulting currency adjustments will offer significant opportunities for those ready and able to exploit them.
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Antony John is the chief executive officer of The ECU Group

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