Introduction to Foreign Exchange

Global FX Strategy 29 August 2012

Introduction Introduct ion to Foreign Exchange

Global FX Strategy John Normand

AC

(44-20) 7134-1816 [email protected] J.P. Morgan Securities plc

John Normand Managing Director Head, Global Global FX Strategy +44 20 7134 1816 [email protected] See Se e page 3 for analyst certi fication and important dis closures. closur es. www.morganmarkets.com/GlobalFXStrategy www.morganmarkets.com

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Foreign exchange exchange is certainly the largest and probably the most m isunderstood isunderstood financial market market in the world. Daily trading volumes in FX across all products total total some $4 trillion, which is more than five times that of equities. Currency Currency exposure exposure is unavoidable for global investors i nvestors and corporates, corporates, since cross-border activity usually requires a f orex transaction. Currency Currency markets m arkets can also be highly politicised, since some governments consider FX l evels evels and volatility volatili ty components components of their macroeconomic and industrial policy. Yet despite the currency markets’ size, scope and policy dim ensions, they remain enigmatic to m any. Academics Academics claim that currency movements are random, which im plies that forecasting and trading are futil e pursuits. Many investors and risk managers agree with their conclusion, so either ignore currency fluctuations, which leaves them exposed to considerable considerable short-term volatility, or routinely hedge hedge all exposure, which can incur high operational costs and forgo profit opportunities. Both the academic literature and common hedging practices obscure the reality that currencies do observe some core macroeconomic principles, that their movements can be modelled and that their patterns have been exploited profitably by investors and hedgers for years. This handbook , originally written for J.P. Morgan’s Analyst Training Program, integrates the conventional wisdom on currencies with best practice on currency overlay and hedging policy developed by J.P. Morgan Global FX Strategy over the past decade. The goal is to address the questions most frequently asked by institutional and corporate clients rather than to cover dealing mechanics treated in standard texts. Five sections cover (1) size, structure and management of global currency markets; (2) fundamental drivers of exchange rates; (3) modelling and forecasting exchange rates; (4) common comm on trading strategies strate gies for investors; and (5) managing managi ng FX hedge ratios for iinvestors nvestors and Appendices outline several J.P. Morgan currency indices for spot and volatility; detail detail liquidity l iquidity statistics corporates. Appendices across products; products; and provide tim elines for for major m ajor events events in i n the currency currency markets during the post-Bretton Woods era (since 1971). Throughout the presentation are references to the historical evolution of the international monetary system since many of the policy issues driving currencies now have been recurring themes in global currency markets over the past





















Forex markets are unique from four perspectives . They are the most liquid in the world; they trade continuously from Sunday 20:15GMT (when Auckland opens) to Friday 22:00GMT (when New York closes); transactions are largely overthe-counter; and they can be heavily managed through government intervention, particularly in the emerging markets. Daily forex turnover turnover across across all products – spot, forwards, forwards, FX swaps and options options – averages $4 $4 trillion (chart one), the majority of which iis s spot (37%) and FX swaps (44%). Even daily spot volumes ($1.5trn) dwarf equity market turnover, which totals less than $250bn for cash and futures trading of the world’s five largest equity markets (S&P500, Nasdaq, Nikkei, FSTE and DAX). Over the past decade total turnover has more than tripled from $1.2trn to almost $4trn, with much greater increases in spot (+280%), forwards (+280%) (+280%) and options (245%) than in swaps (+170%). Major currencies (USD, EUR, JPY, GBP) account for more than 75% of global volumes, but the growth rate of emerging market currency volumes over over the past decade has been explosive (>25% annual increases in some markets). London has always dominated global trading and now accounts for 37% of global volumes (chart two). Turnover in New York is half that amount (18%), followed by Tokyo (6%), Singapore, Hong Kong, Switzerland (each 5%) and Sydney (4%).





















Though FX remains the most liquid market in the world, its depth has been diminishing over the past two years requirements), a mediocre for the same reasons reasons as in other markets -- rising regulation (which increases capital requirements), global economic expansion (which reduces ri sk-taking and cross-border trade/capital flows) and policy uncertainty cross-border from the EMU debt crisis and US fiscal cliff (which discourages investment). To illustrate diminishing cross-border activity post-Lehman, the first chart highlights the stagnation in global exports over the past year and the second shows the plunge in cross-border cross-border M&A. International International portfolio investment investment has also declined declined over the past year, though the downtrend downtrend is not as dramatic as with M&A. How these forces impact liquidity is harder harder to determine determine in FX than in other m arkets since most FX trading is over-theover-thecounter and and since the m ost comprehensive comprehensive survey survey of global FX activity – the Bank for International Settlements’ Settlements’ Triennial Central Bank Survey - will not be conducted again until 2013. The second-best alternative is the collection of semi-annual survey sconducted by the Foreign Exchange Market Committee operating under central bank sponsorship in the UK, US, Australia, Canada Canada and Singapore (Japan’s FX committee com mittee only surveys m arket participants annually). annually). Previous J.P. Morgan research has found that daily FX futures volumes on the Chicago Mercantile Exchange (CME) closely track this lower-frequency survey data even though futures activity equals less than 10% of OTC spot and forwards trading (see is FX liquidity abnormally low? , Normand, April 4, 2012). Thus daily futures data can approximate approximate real-time volume trends. trends. As shown in the second chart, FX volumes have been contracting over the past year as cross-border activity has declined. Based on a simple econometric model model linking global FX volumes to global economic activity (measured by J.P. Morgan’s global PMI index) and European sovereign spreads (as a proxy for uncertainty created by the sovereign crisis), we construct two scenarios for volume growth. A global stagnation scenario (2% global GDP growth, 150bp wider peripheral peripheral spreads) implies almost no pick up in FX volumes this year (2% rise in turnover across products), products), which would mark the slowest pace outside of the Lehman crisis. Conversely, a global stability scenario (3% global GDP growth, 100bp narrower narrower spreads) implies annual volume growth in all FX products of about 12%, so still below the long-run





















Currency markets are disproportionately dollar-centric, whether judged by transaction or investment demand. The dollar is involved in 85% of FX transactions t ransactions (chart 1), and it constitutes over over 60% of the world’s foreign exchange exchange reserves (chart 3). Although the US economy’s size and the depth of its asset markets should create unrivalled demand for dollars for trade and investment, the dollar’s role is disproportionate. The The US accounts for only 25% of the global economy economy and its bond m arket only 25% of the global government bonds bonds outstanding, yet yet turnover in the dollar is 20% higher than would be predicted by the size of the US economy (chart 2). Appendix tables 1 and 2 list average daily turnover globally for spot and options markets by currency, to highlight the dollar’s dominance. dominance. Note that the Chinese renminbi is grossly underrepresented in global markets relative to the size of the Chinese economy. Turnover should be closer to $350bn per day rather than the $48bn reported. This is largely due to restrictions on internationalisation of the renminbi and capital controls which are easing slowly. Dollar centrism has been deliberate feature of the international monetary system . From 1944 until 1971, the dollar was the anchor currency for the Bretton Woods system which pegged all currencies to the dollar and fixed the dollar to gold at a rate of $35/oz. Under the agreement, the US pledged to exchange its currency for gold at the agreed rate, and other countries agreed to keep their currencies within 1% bands around fixed parities through interventions, restraints on financial flows or compatible monetary policies. policies. When faced with a transitory balance of payments problem, problem, a country could borrow from the IMF to finance intervention intervention rather than i nstitute deflationary deflationary macroecono macroeconomic mic programs (such as peripheral Europe is pursuing now within EMU). That system prevailed until August 1971 when a US balance of payments crisis triggered by a growing fiscal deficit and rising inflation prompted a series of m ini-USD devaluations devaluations and an eventual eventual shift to freely-floating exchange exchange rates for the major economies by March 1973. Even during the floating rate era, however, the dollar has remained the world’s global currency due to lack of alternatives and investment/trading inertia . Recall that the US had no rivals as a single-























Even after Bretton W oods collapsed, collapsed, many countries maintained hard pegs, crawling pegs or managed floats against the dollar to anchor inflation or maintain export export competitiveness. competitiveness. Most Gulf economies have pegged their currencies to the dollar since the mid-1980s, though Kuwait repegged to a basket in 2007. In Latin America, America, Mexico maintained a crawling peg until 1994, Brazil a crawling peg until 1999 and Argentina a currency board until 2002. 2002. Venezuela still pegs to the dollar. In CEEMEA, Russia maintained a crawling peg until 1998 and Turkey until 2001. Emerging Asia’s dollar focus has been the most pronounced over the past decade, even though these currencies are now officially floating. China pegged the renminbi to the dollar from 1994 to 2005, and even once the PBoC floated the currency, currency, it still maintained daily fluctuation limits (now +/- 1% versus the daily fixing) which resulted in unprecedente unprecedented d reserve accumulation of $3 billion over the past decade. The rest of the region mimicked China’s policies despite having floated their currencies during the Asia Crisis. Collectively EM Asia ex-China (Korea, India, Hong Kong, Singapore, Malaysia, Indonesia, Philippines) amassed some $1.3 trillion in reserves over the past decade (see Appendix table 3), thus perpetuating an unofficial, managed exchange rate system known as Bre Wood Wood II





















The dollar’s dominance has been declining over the past decade but only glacially. In terms of transactional demand, the dollar’s share of total forex turnover (slide 3 chart 1) has only fallen by five percentage points in a decade, from 90% in 2001 to 85% in 2010. Its role as a reserve reserve currenc currency y has been declining more sharply but remains dominant. A reserve currency is any medium in which central banks hold their foreign assets. In theory reserves can be any asset which satisfy three criteria: liquid (freely transacted without moving the price); convertible (no government government restrictions on buying or selling); and stable (it retains its purchasing power power over time). t ime). Sterling was the world’s currency in the 19 th century in line with the British Empire’s dominance, though now sterling is used in only 13% of global currency currency transactions (slide 3 chart 1) and constitutes only 4% of global foreign exchange reserves. Gold is the alternative to fiat currencies as a reserve asset and indeed anchored the global monetary system from 1870 to 1914. Under the gold standard, central banks pegged their currencies to bullion at a fixed rate and held gold as official reserves. Most countries scrapped their gold pegs during World War I to facilitate money printing, although many countries tried unsuccessfully unsuccessfully to re-peg to gold during the inter-war years (1918 to 1944).





















How long before the renminbi rivals the dollar or the euro? The questions should be phrased more broadly as how does the world create more reserve assets. As noted on slide 7, reserve assets can be any currency which is liquid, convertible convertible and stable. Many currencies are convertible and retain value over ti me, but few offer sufficient liquidity to accommodate the world’s largest central banks and sovereign wealth funds. Liquidity is relative: a market which is deep enough for a central bank with $50bn in reserves may not be deep enough for a central bank with $250bn of reserves. The FX turnover statistics on slide 3 and in appendix table 1 provide one perspective on liquidity by currency. An additional measure is the size of government bond markets, since bonds constitute the largest share of a reserve manager’s asset allocation. The US, Euro area and Japanese bond markets are the deepest, with close to $5trn in outstanding debt. The UK is fourth, with outstandings of $1.1trn (first chart). Only four other bond markets offer outstandings exceeding $250bn : China ($380bn), Canada ($350bn), Korea ($260bn) and India ($250bn). Other AAA sovereign bonds markets in the G-10 (Sweden, Denmark) offer debt of only





















Over the next few decades, however, the dollar and euro will have more rivals. The tables above track four indicators for monitoring the rise and fall of the world’s reserve currencies: (1) central banks’ current allocation of their FX reserves as measured by the IMF’s quarterly COFER survey, which proxies investment demand; (2) the distribution of global foreign exchange turnover reported in the BIS’s triennial survey, which measures transaction demand;( 3) size of the government bond market, market , which measures a currency’s investment suitability for large reserve holders; and (4) share of potential transaction demand due to trade invoicing. world exports, exports, which measures potential challenger to the dollar. Although the IMF By allocation of FX reserves, reserves , no currency rivals the euro, which is the only challenger aggregates all minor currencies (those other than USD, EUR, GBP, JPY and CHF) into the “other category”, collectively these currencies’ share of global reserves has risen only from 4.8% in 1998 to 5.3% in 2010. even the euro has m ade limited inroads inroads against the dollar. dollar. According to the By the distribution of global FX turnover , even most recent recent BIS survey in 2010, the dollar is used in 85% of forex transactions only, down from 87% in 1998. The euro is





















Judged by the previous four metr ics, the renminbi is at least a decade from becomi ng a major reserve asset even though China’s role in global trade offers it a clear liquidity advantage over minor reserve currencies such as AUD and CAD. For the moment, howeve however, r, the t he renminbi role is more potential potential than actual. As discussed on slide 3 and highlighted again here in chart 1, the renminbi is grossly underrepresented in global foreign exchange turnover. This is largely due to restrictions on on internationalisation internationalisation of the renminbi which limit li mit the use of the currency for trade settlement, and to capital controls. There There are no statistics on reserve holdings of renminbi, but these are probably trivial relative to global wealth. Until 2010, CNY was only accessible as a non-deliverable currency, which means investors take exposure exposure through thro ugh a USD-settled forward whose value is linked to USD/CNY’s value at a future date. The launch of CNH, which is deliverable renminbi trade offshore in Hong Kong (chart 2), now provides a vehicle for taking direct exposure to the currency. Certainly the renminbi is on the path towards reserve currency status and becoming a currency for global trade. The uncertainty centres on the timeline. timeline. China has taken several steps to raise the renmindi’s role in international trade and finance. In terms of offshore trade settlement, the authorities allow Hong Kong-registered companies to accept renminbi























Since the renminbi’s ascent ascent requires decades, some have suggested that the IMF’s Special Drawing Rights (SDR)





















Why should any country aspire to reserve currency status? It’s more than a prestige issue. The country issuing the world’s





















In additional to the shift toward a multi-polar reserve system, the other structural change in currency markets





















The question of what drives markets seems to confound investors and hedgers more in currencies than in core





















A common comm on perception perception amongst academics and market m arket participants is that currency movements are random. If they are,































































































































































































































































































































































































































































































































































































































































































































































































































Most of the previous section applied to investors. Corporate face additional challenges. The most frequent questions centre on five points: 1. Coverage: should the balance sheet or or only cash flows be hedged? Most corporates would not hedge balance sheet exposure if they plan to be invested in the country for a very long time. The cost could also be substantial given the size of foreign exposure. Private equity firms are most likely to hedge the investment since they intend to dispose within a few years. Corporates tend to hedge cash flows only, on a rolling basis. 2. Hedge ratios: ratios: should all known cash flows are only a portion of them be hedged? Optimal hedge ratios are not uniform across corporates. corporates. Depends on predictability of of cash flows, tightness of margins, natural currency diversification of the firm’s business and treasury’s ability to forecast exchange exchange rates. In J.P.Morgan’s J.P.Morgan’s quarterly Corporate Hedging Survey , corporates on average hedge 75% of quarter-ahead cash flows and 25% of year-ahead. 3. Management: Management : should hedge be centralised with the parent company or delegated to local subsidiaries? Centralised hedging takes portfolio approach to the firm’s exposure, so benefits from netting. In many EM currencies (Asia), however, exchange controls could require require the local subsidiary to hedge onshore. Most corporates centralise hedging unless exchange controls are prohibitive.





















4. Instruments: should hedging be done with forwards or options? Forwards are considered simpler, less-risky instruments because they guarantee a conversion rate for future cash flows. Still, many corporates are reluctant to hedge when foreign rates are above domestic ones, thus entailing a negative carry hedge. The conventional wisdom on forwards understates their limitations. Options such as vanilla currency puts have the advantage of entailing a defined downside (premium paid) and can be structured as zero-cos zero-costt instruments (risk reversals/collars). reversals/collars). 5. Timing: Timing: should hedging be done on a fixed schedule or opportunistically? Fixed hedging every month, quarter or year should be done when when the objective is to mi nimise cash flow volatility and the corporate has no view on currency direction. Opportunistic hedging is more cost-effective when the corporate has some success in identifying the currencies most vulnerable to a large move. The treasurer could control for forecast error by hedging less than 100%.





















6. Proxy hedging: should more-liquid currencies be used to hedge less-liquid ones? The merit of proxy hedging depend on four variables: (1) beta between underlying exposure (asset/earnings stream) and proxy variable; (2) liquidity of underlying versus proxy; (3) cost of underlying versus proxy; and (4) size of underlying exposure relative to total portfolio/corporate exposure. Proxy hedging is sensible where the exposure is meaningful, the beta high, the liquidity deeper elsewhere and the cost cheaper. c heaper.







































































































































































































































































































































Introduction to Foreign Exchange

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