Currency Strategy

Acknowledgements xiii
Biography xv
Introduction 1
Part One Theory and Practice 15
1 Fundamental Analysis: The Strengths and Weaknesses of Traditional
Exchange Rate Models 17
1.1 Purchasing Power Parity 17
1.1.1 Reasons for “Misalignments” 19
1.1.2 Tradable and Non-Tradable Goods 20
1.1.3 PPP and Corporate Pricing Strategy 20
Example 1 20
Example 2 22
1.1.4 PPP and the Real Exchange Rate 24
1.2 The Monetary Approach 25
1.2.1 Mundell–Fleming 27
1.2.2 Theory vs. Practice 29
1.2.3 A Multi-Polar rather than a Bi-Polar Investment World 30
1.2.4 Two Legs but not Three 30
1.2.5 Implications for EU Accession Candidates 31
1.3 The Interest Rate Approach 31
1.3.1 Real Interest Rate Differentials and Exchange Rates 33
1.4 The Balance of Payments Approach 34
1.4.1 A Fixed Exchange Rate Regime 35
1.4.2 A Floating Exchange Rate Regime 36
1.4.3 The External Balance and the Real Exchange Rate 37
1.4.4 REER and FEER 38
1.4.5 Terms of Trade 39
1.4.6 Productivity 39
viii Contents
1.5 The Portfolio Balance Approach 41
Example 42
1.6 Summary 43
2 Currency Economics: A More Focused Framework 47
2.1 Currencies are Different 48
2.1.1 (In)Efficient Markets 48
2.1.2 Speculation and Exchange Rates: Cause, Effect and the Cycle 49
Example 50
2.1.3 Risk Appetite Indicators and Exchange Rates 53
2.2 Currency Economics 57
2.2.1 The Standard Accounting Identity for Economic Adjustment 58
Example 1 59
Example 2 60
2.2.2 The J-Curve 62
Example 62
2.2.3 The Real Effective Exchange Rate 63
2.3 Summary 63
3 Flow: Tracking the Animal Spirits 65
3.1 Some Examples of Flow models 69
3.1.1 Short-Term Flow Models 70
3.1.2 Medium-Term Flow Models 77
3.1.3 Option Flow/Sentiment Models 82
3.2 Speculative and Non-Speculative Flows 83
3.3 Summary 84
4 Technical Analysis: The Art of Charting 85
4.1 Origins and Basic Concepts 85
4.2 The Challenge of Technical Analysis 86
4.3 The Art of Charting 87
4.3.1 Currency Order Dynamics and Technical Levels 87
4.3.2 The Study of Trends 90
4.3.3 Psychological Levels 90
4.4 Schools of (Technical) Thought 100
4.5 Technical Analysis and Currency Market Practitioners 102
Part Two Regimes and Crises 105
5 Exchange Rate Regimes: Fixed or Floating? 107
5.1 An Emerging World 108
5.2 A Brief History of Emerging Market Exchange Rates 109
1973–1981 109
1982–1990 109
1991–1994 109
1995– 109
Contents ix
5.2.1 The Rise of Capital Flows 110
5.2.2 Openness to Trade 111
5.3 Fixed and Pegged Exchange Rate Regimes 111
5.3.1 The Currency Board 112
5.3.2 Fear and Floating 112
5.3.3 The Monetary Anchor of Credibility 113
5.4 Exchange Rate Regime Sustainability— A Bi-Polar World? 114
5.5 The Real World Relevance of the Exchange Rate Regime 116
5.6 Summary 118
6 Model Analysis: Can Currency Crises be Predicted? 119
6.1 A Model for Pegged Exchange Rates 120
6.1.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation 120
6.1.2 Phase II: The Irresistible Force and the Moveable Object 121
6.1.3 Phase III: The Liquidity Rally 123
6.1.4 Phase IV: The Economy Hits Bottom 124
6.1.5 Phase V: The Fundamental Rally 125
6.2 A Model for Freely Floating Exchange Rates 128
6.2.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation 128
6.2.2 Phase II: Speculators Join the Crowd — The Local Currency
Continues to Rally 128
6.2.3 Phase III: Fundamental Deterioration — The Local Currency
Becomes Volatile 129
6.2.4 Phase IV: Speculative Flow Reverses — The Local Currency
Collapses 130
6.3 Summary 133
Part Three The Real World of the Currency Market Practitioner 135
7 Managing Currency Risk I — The Corporation: Advanced
Approaches to Corporate Treasury FX Strategy 137
7.1 Currency Risk 138
7.2 Types of Currency Risk 140
7.2.1 Transaction Risk 140
7.2.2 Translation Risk 140
Example 141
7.2.3 Economic Risk 142
7.3 Managing Currency Risk 143
7.4 Measuring Currency Risk — VaR and Beyond 143
7.5 Core Principles for Managing Currency Risk 144
7.6 Hedging — Management Reluctance and Internal Methods 146
7.7 Key Operational Controls for Treasury 147
7.8 Tools for Managing Currency Risk 148
7.9 Hedging Strategies 150
7.9.1 Hedging Transaction Risk 150
7.9.2 Hedging the Balance Sheet 150
x Contents
Example 151
7.9.3 Hedging Economic Exposure 152
7.10 Optimization 152
7.11 Hedging Emerging Market Currency Risk 153
7.12 Benchmarks for Currency Risk Management 154
7.13 Budget Rates 154
7.14 The Corporation and Predicting Exchange Rates 155
7.15 Summary 156
8 Managing Currency Risk II — The Investor: Currency
Exposure within the Investment Decision 157
8.1 Investors and Currency Risk 157
8.2 Currency Markets are Different 158
8.3 To Hedge or not to Hedge — That is the Question! 159
8.4 Absolute Returns — Risk Reduction 159
8.4.1 Passive Currency Management 160
8.4.2 Risk Reduction 160
Example 161
8.5 Selecting the Currency Hedging Benchmark 161
Example 162
8.6 Relative Returns — Adding Alpha 163
8.6.1 Active Currency Management 163
8.6.2 Adding “Alpha” 163
8.6.3 Tracking Error 165
8.7 Examples of Active Currency Management Strategies 166
8.7.1 Differential Forward Strategy 166
8.7.2 Trend-Following Strategy 167
Example 169
8.7.3 Optimization of the Carry Trade 169
8.8 Emerging Markets and Currency Hedging 171
8.9 Summary 173
References 173
9 Managing Currency Risk III— The Speculator: Myths, Realities and
How to be a Better Currency Speculator 175
9.1 The Speculator — From Benign to Malign 175
9.2 Size Matters 179
9.3 Myths and Realities 179
9.4 The Speculators — Who They Are 180
9.4.1 Interbank Dealers 180
9.4.2 Proprietary Dealers 181
9.4.3 “Hedge” Funds 182
9.4.4 Corporate Treasurers 183
9.4.5 Currency Overlay 184
9.5 The Speculators — Why They Do It 185
9.6 The Speculators — What They Do 185
9.6.1 Macro 186
Contents xi
9.6.2 Momentum (and Fellow Travellers) 186
9.6.3 Flow 187
9.6.4 Technical 187
9.7 Currency Speculation— A Guide 187
9.8 Summary 190
10 Applying the Framework 193
10.1 Currency Economics 193
10.2 Flow Analysis 193
10.3 Technical Analysis 194
10.4 Long-Term Valuation 195
10.5 The Signal Grid 195
10.6 Risk Appetite Indicators 195
10.7 Exchange Rate Regimes 196
10.8 Currency Crises and Models 197
10.8.1 CEMC 197
10.8.2 The Speculative Cycle 197
10.9 Managing Currency Risk I — The Corporation 197
10.9.1 Types of Currency Risk 197
10.9.2 Internal Hedging 198
10.9.3 Key Operational Controls for Treasury 198
10.9.4 Optimization 198
10.9.5 Budget Rates 199
10.10 Managing Currency Risk II — The Investor 199
10.10.1 Absolute Returns: Risk Reduction 200
10.10.2 Selecting the Currency Hedging Benchmark 200
10.10.3 Relative Returns: Adding Alpha 200
10.10.4 Tracking Error 201
10.10.5 Differential Forward Strategy 201
10.10.6 Trend-Following Strategy 201
10.10.7 Optimization of the Carry Trade 202
10.11 Managing Currency Risk III — The Speculator 202
10.12 Currency Strategy for Currency Market Practitioners 202
10.12.1 Currency Trading 203
Example 203
10.12.2 Currency Hedging 206
Example 206
10.13 Summary 208
Conclusion 211
Index 215