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The Foreign Exchange Market



n GSDEER re-estimation and equity investments

n Extended BBoP and real TWI analysis
n Robustness of cross-asset proxy baskets
n Portfolios of macro-thematic FX Currents baskets
n Output gaps and growth differentiation in FX markets
Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

The Foreign Exchange Market

October 2009

Introduction and Summary 1

1. GSDEER—Re-Estimation and Test-Based Adjustment 2

Thomas Stolper, Anna Stupnytska and Malachy Meechan

2. Using GSDEER to Trade Equities 14

Dominic Wilson and Roman Maranets

3. Measuring Global Output Gap Dispersion as a Guide for Relative Growth Strategies 18
Mark Tan

4. The Benefits of Investing in Portfolios of FX Currents 22

Themistoklis Fiotakis

5. Updating our Trade-Weighted Exchange Rates and Looking at the Real TWIs 27
Fiona Lake, Roman Maranets and Swarnali Ahmed

6. Empirical Links Between the Major Currencies and their BBoP Flows 32
Fiona Lake and Thomas Stolper

7. Over-fitting in Cross-Asset Proxy Baskets 37

Thomas Stolper

8. FX Volatility Still Looks Expensive Relative to Cyclical Factors 48

Themistoklis Fiotakis

October 2009
Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Introduction and Summary

Welcome to the 13th edition of The Foreign Exchange Market. As usual, the book is designed to supplement our
ongoing FX and financial market research. In this issue we have once again combined deeper work on some of our
existing toolkit with new research into the FX market.

Chapter One re-estimates our flagship GSDEER ‘fair value’ model, incorporating the additional data published since
the last update nearly two years ago. The framework remains broadly the same but the estimated coefficients change
slightly. We also introduce a new test-based adjustment procedure to correct biases in the level of some of our ‘fair
value’ estimates.

Chapter Two presents an innovative use of GSDEER FX valuation signals to trade equity markets. The basic idea is
that the real appreciation of undervalued currencies will occur through nominal appreciation and/or rising prices in
goods and asset markets. FX unhedged exposure to equity markets with undervalued currencies is a way of capturing
both possible appreciation channels simultaneously.

Chapter Three analyses the performance of FX growth differentiation strategies through the business cycle. It appears
that during the early stages of recovery, such as the current juncture, the change in output gaps is a particularly
valuable differentiation signal for FX investors. We also introduce a new growth dispersion measure that can be used
to identify periods of likely outperformance of growth differentiation strategies.

Chapter Four provides guidance on how to construct baskets of FX Currents with high Sharpe ratios. The Currents
are the fully tradable replacements of our old FX Slices.

Chapter Five introduces real trade-weighted exchange rate indices to complement our nominal GS TWIs. We also
publish the latest annual revision of the underlying weights. Once again, the weights for EM currencies have increased,
reflecting continued globalisation.

Chapter Six builds on the BBoP modelling framework introduced in the previous edition and analyses empirically the
balance of payments components that drive the main currencies. We find further evidence for the validity of our BBoP
concept, although country-specific differences persist.

Chapter Seven pushes the cross-asset correlation analysis to the limit. By constructing deliberately over-fitted FX
proxy baskets for non-FX assets, we can illustrate the limits of this approach. However, we also find clusters of relative
robustness, which suggest FX proxy baskets may work precisely when they are also most useful for investors.

Chapter Eight looks at the cyclical patterns in FX volatility, and suggests that both realised and implied volatility will
likely continue to decline as the business cycle advances.

Thomas Stolper

October 22, 2009

1 October 2009
Goldman Sachs Global ECS Research The Foreign Exchange Market

Chapter 1: GSDEER—Re-Estimation and Test-Based Adjustment

We have updated our GSDEER model, while maintaining the same framework as before. The primary aim was
to re-estimate the coefficients on the basis of 11 additional quarters of new data, now covering the period from
1Q1980 to 4Q2008. In addition, we have adjusted the fixed effects for 12 countries using a cross-sectional link
between GDP per capita relative to the US and deviation from PPP. This kind of adjustment had previously
been used for CEE countries only. The new ‘fair value’ estimates have barely changed for most major
currencies; however, there are some notable shifts in EM. The Dollar remains broadly undervalued.

Overview and Modelling Philosophy Table 1: Changes to Coefficients

Back in May 2005, we introduced a new unified
Variable Old coefficient New coefficient
GSDEER framework for Major and Emerging Market
(EM) currencies, which is based on the idea that long-run Productivity -0.239 -0.189
variations in the real exchange rate can be explained Terms of trade -0.484 -0.378
through productivity and terms of trade (ToT) Source: GS Global ECS Research
fixed effects for all currencies. As we explain in more
We occasionally re-estimate our model to incorporate the detail below, this adjustment helps correct for level
additional data that has been released since the previous problems linked to short sample size or heavily managed
update. The stability of the coefficients is one important exchange rate regimes. For those countries where our
test to assess the robustness of our framework. We also test favours an adjustment, we will adjust the estimated
use the opportunity to introduce additional modifications fixed effect to make it consistent with a second cross-
to address issues that may have appeared since the latest sectional model, which is a more sophisticated version of
re-estimation. For example, in the previous re-estimation the one already used for the CEE countries in the past.
in 2007, we dropped a right-hand variable, the This second model is based on the idea that over, long
international investment position, which had lost all timeframes and across countries, currencies become less
explanatory power. ‘cheap’ as the population becomes wealthier on a GDP-
per-capita basis.
Our latest model update includes the following changes
(Chart 1 illustrates the procedure schematically):
New Coefficients Incorporate the Commodity Boom
We have re-estimated the model once again, using As Table 1 shows, both coefficients are now lower than
additional data that has been released since the last re- in the previously estimated model. The fall in the value of
estimation. The coefficients have changed slightly but the terms of trade coefficient is consistent with the fact
in line with what we would have expected given the that the additional data used in the extended sample
substantial increase in commodity market volatility in contains a lot more commodity-related volatility than the
recent years. earlier periods. With more variation in the variable, it is
normal that the coefficient can decline to explain similar
We have replaced the CEE-specific adjustment factors in levels of exchange rate variation. This change in the
favour of a test-based framework that helps calibrate the coefficient also has to be seen as a welcome change given

Chart 1. GSDEER Re-Estimation and Adjustment Procedure

GSDEER Re-estimation Estimation of PPP-Implied Fair Values

Longer Sample: 1Q1980-4Q2008

New Coefficients and Country-Specific Fixed Effects Calculation of Adjustment Factors from PPP-Implied
Misalignment and GSDEER Misalignment

Unit Root Test of Residuals for Each Country

Unit Root Probability Ranking

Country Selection for Fixed Effects Adjustment Adjustment of Fixed Effects for Selected Countries

New GSDEER Fair Values for All Currencies

Source: GS Global ECS Research

1. Global Economics Paper 124, “Merging GSDEER and GSDEEMER: A Global Approach to Equilibrium Exchange Rate Modelling”, May 2005.

Chapter 1 2 October 2009

Goldman Sachs Global ECS Research The Foreign Exchange Market

that large fluctuations in recent commodity prices had Eastern European countries2. We then adjusted the ‘fair
become a source of rapid change in the ‘fair values’ of values’ of the CZK, HUF, PLN and RUB and have been
commodity-exporting countries. The coefficient on using these estimates since then. However, a number of
productivity has become smaller as well, and this could countries from other regions also potentially fall into this
also have resulted from more variation in the explanatory group, and we have therefore decided to make equivalent
variable. In particular, over the last few years of adjustments to all countries and currencies where the
globalisation, a growing cross-country divergence of aforementioned issues cause concern.
productivity growth may have been a factor, in particular
in the emerging world. Both coefficients remain highly While our approach rests on the same logic as before, it is
significant. now a more structured two-step procedure. First, we
determine which countries are mostly likely to be subject
to the level bias by running residual-based tests for
Issues Related to ‘Fair Value’ Level Estimates cointegration for each currency in our model. Second, we
As explained in more detail in the original GSDEER adjust GSDEER ‘fair values’ for the selected currencies
paper mentioned above, we estimate ‘fair value’ on the by estimating the PPP-implied equilibrium values from a
basis of a panel cointegration framework with so-called cross-sectional PPP regression. This involves calibrating
country-specific ‘fixed effects’. This simply means a the individual countries’ fixed effects from the panel,
currency-specific constant, which ensures that the while keeping the estimates of the long-run elasticities for
average of the observations equals the average of the differentials in terms of trade and productivity unchanged.
much smoother ‘fair value’ estimates over the sample
period. This is fine as long as we have a long timeframe
and a large number of swings of the exchange rate around GSDEER Adjustment: Testing for Cointegration
the true fundamental ‘fair value’. Technical aspects. Standard tests for cointegration are
closely related to unit root tests3. If a long-run
However, most countries in our cross-section, particularly relationship between the fundamentals in our model and
EMs, have had a number of currency regimes over time— the real exchange rate exists (i.e., the variables are
pegs, various floats and currency boards. Artificial cointegrated), then the error term (or residuals from the
management of currencies, transitions between regimes model) must be stationary. If there is no cointegration,
and other factors have in most cases caused movements in the residuals will follow a unit root process.
exchange rates, which were not necessarily reflective of
fundamentals. Even very long-term averages of managed A number of residual-based tests for cointegration exist.
exchange rates may be considerably different from the But tests of this nature tend to be very sensitive to finite
true fundamental ‘fair value’. Arguably, inflation (short) samples, specific features of the data-generating
differentials would compensate for nominal pegs and still process (heteroskedasticity, serial correlation) that are
allow some real exchange rate variation, which we would generally unknown, structural breaks and seasonally
capture in our GSDEER model. However, any form of adjusted data. This leads to severe reductions in power
stickiness in inflation processes or data problems linked to (the ability to reject the null hypothesis of a unit root (no
selection of the most appropriate inflation measure would cointegration) when it is actually false) and means that
likely introduce new sources of error. failure to reject noncointegration may provide only weak
evidence that the series of interest are in fact not
An additional problem arises in some countries where the cointegrated.
data sample may be too short to gain a good sense of
what the long-term averages are (even in the case of a In our case, the finite samples and structural breaks are
freely floating exchange rate). For example, looking at exactly the problems we are facing (and trying to correct
EUR/$ over just the last five years could create the for), which means that the unit root tests on the residuals
impression that ‘fair value’ is somewhere in the region of from GSDEER are bound to have low power. As a result,
1.30-1.40, whereas most long-term models suggest ‘fair some residual series that are identified as unit roots
value’ is in the 1.00 to 1.20 area. As we have pointed out according to the tests could in theory still be stationary.
in the past, this problem is particularly severe in Eastern There is no simple mechanical solution to this problem
Europe, which has still relatively short time series data. and largely any decision must involve a judgement call.
To avoid any ad hoc and arbitrary selection procedure,
Interestingly, these data problems will almost certainly we choose to concentrate on the ranking of currencies
show up in standard cointegration tests. While our full according to their test results rather than on the actual test
panel satisfies the usual criteria, individual countries with statistics and corresponding critical values.
the problems described above will likely show signs of
non-stationarity in the country-specific residuals. We use the Phillips-Perron unit root test, which has an
advantage of being non-parametric and thus does not
We have acknowledged this issue before and argued that require specification of the exact form of serial correlation
it was particularly pertinent in the context of Central and

2. Refer to Global Viewpoint 07/03: “The Evolving GSDEER Currency Model”, January 25, 2007.
3. Tests for cointegration are effectively unit root tests on residuals, although the asymptotic distributions of the corresponding test statistics are not
the same as those of ordinary unit root test statistics—as a result, different critical values have to be used.
Chapter 1 3 October 2009
Goldman Sachs Global ECS Research The Foreign Exchange Market

Table 2: Phillips-Perron Test Results bias problems recede and more cycles in the data appear
Fixed Effect to have reduced the importance of structural breaks. We
Adjustment Factor* thus chose to leave the RUB unadjusted. In a similar
CZK 0.8791 -29.8 vein, we would expect the number of currencies requiring
HUF 0.8146 -13.7 re-adjustment to decrease over time as the availability of
TRY 0.7724 -13.9 longer time series with more cyclical swings makes the
HKD 0.7521 -16.3 estimation of long-term equilibrium values in our regular
PEN 0.7199 15.5 GSDEER panel much more reliable.
TWD 0.6609 -11.3
MYR 0.6359 -6.9
BRL 0.6051 9.7 GSDEER Adjustment: Estimating PPP-Implied ‘Fair
CNY 0.5873 -8.6 Values’
SGD 0.5738 -36.8 In our previous adjustment of CEE currencies, we
ARS 0.5525 0.9 exploited the cross-sectional link between the gap
PLN 0.3790 -29.8
between PPP exchange rate and spot exchange rate, and
* The probability of the null hypothesis of unit root (i.e. non-stationarity of
residuals) being true ** Difference betw een PPP-implied misalignment and
GDP per capita levels in PPP relative to the US.
GSDEER misalignment on average over 1995-2007
Source: GS Global ECS Research One problem we encountered in this PPP-based
(which is certainly an issue in our context) . We rank the 4 framework is that some countries still have very large
countries according to their test results—by the agricultural sectors with very low output per head. In
probability of the null hypothesis (of a unit root) being some cases it almost appears as if the countries were split
true. Currencies that score high are most likely to have in two: a competitive industrial and services sector versus
nonstationary residuals and thus require adjustment to a largely self-sufficient and very poor agricultural sector
their ‘fair values’. Table 2 shows the top countries ranked that plays a very small role in global trade. We see
by probability and the corresponding adjustment factors. abundant evidence that global trade barriers remain
As we explain in more detail below, these adjustment disproportionally high for agricultural goods. We
factors represent the difference between PPP-implied therefore found it more appropriate to focus on GDP per
misalignment and GSDEER misalignment for each capita in the industrial and services sectors for all
currency. These factors are used to calibrate fixed effects. countries. Industry and services also account for the
largest share of the tradable sector in most countries, and
Country selection. The countries topping the ranking fall we use the GDP and employment shares of these two
into two broad unifying groups. One group contains those sectors to estimate a rough measure of tradable GDP per
that have undergone periods of rapid economic transition capita. For countries such as China, India, Indonesia and
and experienced major structural shocks and/or currency Turkey, where agriculture accounts for a relatively high
crises (the Czech Republic, Hungary, Turkey and Brazil). share of GDP, the difference is especially significant.
Another group includes countries that used to manage, or
still manage or peg, their exchange rates (Hong Kong, With the new measure in hand, we run a pooled least
Taiwan, Malaysia, China, Singapore and Argentina). squares regression across 37 countries from 1995 to
These results are reassuring as it appears our unit root test 2007. This time period is chosen to exclude the initial
ranking identifies the countries most affected by the transition years in the CEE countries, as the currency
potential biases in ‘fair value’ levels discussed above. movements over that period hardly reflected the
fundamentals and would therefore bias the results. The
In order to decide how far down we go in our unit root equation takes the following form:
ranking, we decided to use the first free-floating G10
currency for which we are reasonably certain that the GDPinUSDi ,t GDPinPPPi ,t × ai
ln( ) = α + β ln( ) + εt
stationarity assumption has been wrongly rejected, GDPinPPPi ,t USGDPinPPPt × aUS
because neither structural breaks nor data issues should
affect the cointegration relationship. Based on the highest
ranked major currency, the Canadian Dollar, used as a w h e r e GDPinUSD i ,t is per capita GDP of country i i n
cut-off point, we end up with 11 currencies needing year t in current US Dollar terms, GDPinPPPi ,t is per
adjustment. In addition, we choose to include the PLN in capita GDP of country i in year t in PPP terms,
this list—even though it ranks below the CAD, the issues USGDPinPPPt is per capita US GDP in t year in PPP
of structural change and small sample bias are highly
likely to distort its ‘fair value’, as we argued before. terms, ai is a ratio of value added in industry and ser-
vices as a share of GDP to employment in industry and
Russia, which previously used to be adjusted, comes services as a share of total employment for country i
much lower in the ranking (on this and other tests),
on average over 1995-2007, ε t is the residual term,
indicating that the above issues may no longer be
important—as time series become longer, small sample α and β are the intercept and slope, respectively.

4. We tried several alternative unit root tests, such as the ADF, KPSS and others. Although they do not yield identical rankings, the broad result
holds across all of them. So we chose the test that requires minimal assumptions.
Chapter 1 4 October 2009
Goldman Sachs Global ECS Research The Foreign Exchange Market

Chart 2: PPP Exchange Rates and GDP per capita

PPP exchange rate (logs)









Tradable GDP per capita relative to US (logs)
-2.8 -2.4 -2.0 -1.6 -1.2 -0.8 -0.4 0.0 0.4
Source: GS Global ECS Research

This cross-sectional relationship accounts for 67% of the we have now produced two GSDEER valuation tables:
variation in PPP gaps. We use the fitted values to one with the Dollar crosses and one with the
calculate the long-term equilibrium value for each corresponding EUR crosses.
currency, which we call ‘the PPP-implied fair value’. The
difference between fitted and actual values (residuals) for This direct comparison throws up some interesting
each country is the PPP-implied currency misalignment. conclusions. For example, Asian currencies appear
We then compare these estimates to the GSDEER broadly in line with GSDEER when looking at the Dollar
misalignments for each currency, on average over the crosses—some are overvalued and some undervalued.
same 1995-2007 period. The difference between the two However, with the Dollar itself undervalued against most
gives the factors by which our GSDEER fixed effects majors, Asian currencies are substantially undervalued
have to be calibrated, translating into corresponding when using a non-Dollar benchmark. There is not a
adjustments in ‘fair values’. Table 2 illustrates the results single Asian currency, including the AUD and the NZD,
for the 12 currencies. that is not undervalued against the EUR currently.

In the subsequent sections, we focus mainly on the

Valuation Benchmark: USD versus EUR changes in ‘fair value’ estimates due to our re-estimation,
Given that our model is consistently estimated on the and hence on the comparable USD values. But in terms of
basis of USD crosses, the primary valuation reference valuation signals, it appears increasingly important to
automatically remains the USD as well. This is not an assess ‘fair value’ relative to both the Dollar and the Euro.
issue when the Dollar is about fairly valued on a trade-
weighted basis. However, it becomes a problem when the
Dollar is substantially overvalued—as it currently is. Summary of PPP-Adjusted GSDEER Estimates
We now briefly discuss the impact of the latest re-
The problem becomes even more complicated if the estimation and adjustment on the currencies in our
foreign exchange world gradually drifts towards a dual selection, highlighting clear regional and structural
reserve currency standard, with the Dollar still themes.
dominating but the Euro becoming increasingly more
dominant. Furthermore, with shifting global trade EUR/CZK, EUR/HUF and EUR/PLN. As expected,
patterns and a trend slowdown in US consumption, the the ‘fair values’ of the CE-3 currencies have become
Dollar may naturally become less of a dominating stronger as the convergence process becomes firmly
reference point. established. GDP per capita has increased since the last
estimation and this has led to stronger ‘fair value’ levels,
For these reasons, it is very important to compare as explained in our adjustment procedure. The PLN now
valuation signals against the Dollar with trade-weighted looks especially ‘cheap’ versus the EUR. This is, of
valuation signals, but also against the Euro. The latter is course, partly also the result of the rapid depreciation
particularly intuitive as a directly quotable FX cross, and during the recent crisis.

Chapter 1 5 October 2009

Goldman Sachs Global ECS Research The Foreign Exchange Market

Table 3: GSDEER Values and Misalignment for USD Crosses Table 4: GSDEER Values and Misalignment for EUR Crosses
GSDEER Current Bilateral GSDEER Current Bilateral
Spot Spot
(4Q09) Misalignment, % (4Q09) Misalignment, %
21-Oct-09 Old New* Old New* 21-Oct-09 Old New* Old New*
G3 G3
EUR/$ 1.49 1.19 1.19 24.80 24.86 EUR/$ 1.49 1.19 1.19 24.80 24.86
$/JPY 90.84 114.00 108.75 25.50 19.71 EUR/JPY 135.39 136.14 129.81 0.56 -4.12
Europe Europe
£/$ 1.64 1.54 1.55 6.49 5.69 EUR/GBP 0.91 0.78 0.77 -14.68 -15.35
$/NOK 5.59 4.63 5.01 -17.20 -10.40 EUR/NOK 8.34 5.53 5.98 -33.65 -28.23
$/SEK 6.96 7.07 7.06 1.56 1.38 EUR/SEK 10.38 8.45 8.43 -18.62 -18.80
$/CHF 1.01 1.24 1.24 22.08 22.21 EUR/CHF 1.51 1.48 1.48 -2.18 -2.12
$/CZK 17.32 22.54 19.83 30.19 14.49 EUR/CZK 25.81 26.92 23.67 4.32 -8.31
$/HUF 177.33 224.80 235.85 26.77 33.00 EUR/HUF 264.29 268.45 281.53 1.57 6.52
$/PLN 2.79 3.43 3.03 22.89 8.53 EUR/PLN 4.16 4.09 3.61 -1.53 -13.07
$/RUB 29.21 35.91 34.96 22.93 19.66 EUR/RUB 43.54 42.89 41.73 -1.50 -4.16
$/TRY 1.47 2.38 1.97 62.13 34.15 EUR/TRY 2.19 2.84 2.35 29.91 7.44
$/ILS 3.70 3.81 4.58 2.97 23.76 EUR/ILS 5.51 4.55 5.46 -17.50 -0.88
$/ZAR 7.37 6.30 6.70 -14.45 -9.05 EUR/ZAR 10.98 7.53 8.00 -31.45 -27.15
Americas Americas
$/ARS 3.82 2.43 2.69 -36.44 -29.56 EUR/ARS 5.69 2.90 3.21 -49.07 -43.59
$/BRL 1.75 2.43 2.76 38.26 57.25 EUR/BRL 2.61 2.90 3.29 10.79 25.95
$/CAD 1.05 1.15 1.17 9.43 11.80 EUR/CAD 1.56 1.37 1.40 -12.32 -10.46
$/MXN 13.05 12.60 12.83 -3.50 -1.69 EUR/MXN 19.46 15.04 15.32 -22.68 -21.26
$/CLP 543.75 381.19 476.57 -29.90 -12.36 EUR/CLP 810.40 455.22 568.87 -43.83 -29.80
$/PEN 2.86 2.90 3.54 1.11 23.43 EUR/PEN 4.27 3.46 4.22 -18.98 -1.14
$/COP 1913.60 1991.13 2252.90 4.05 17.73 EUR/COP 2852.03 2377.81 2689.25 -16.63 -5.71
$/VEB 2.15 2.18 2.65 1.64 23.46 EUR/VEB 3.20 2.61 3.16 -18.56 -1.12
Asia Asia
AUD/$ 0.92 0.91 0.80 1.80 15.79 AUD/EUR 0.62 0.76 0.67 -18.43 -7.26
$/CNY 6.82 6.93 6.87 1.64 0.69 EUR/CNY 10.17 8.28 8.20 -18.56 -19.35
$/HKD 7.75 7.02 6.20 -9.44 -20.01 EUR/HKD 11.55 8.38 7.40 -27.44 -35.94
$/INR 46.17 46.14 46.62 -0.08 0.96 EUR/INR 68.82 55.10 55.65 -19.94 -19.14
$/KRW 1183.60 1395.21 1303.30 17.88 10.11 EUR/KRW 1764.04 1666.16 1555.73 -5.55 -11.81
$/MYR 3.37 2.97 2.71 -11.89 -19.58 EUR/MYR 5.02 3.54 3.23 -29.40 -35.59
NZD/$ 0.75 0.60 0.62 24.21 20.42 NZD/EUR 0.50 0.51 0.52 -0.47 -3.56
$/SGD 1.40 1.62 1.14 16.43 -18.31 EUR/SGD 2.08 1.94 1.36 -6.71 -34.57
$/TWD 32.27 29.72 26.83 -7.92 -16.86 EUR/TWD 48.10 35.49 32.03 -26.22 -33.41
$/THB 33.42 34.12 34.94 2.12 4.57 EUR/THB 49.80 40.75 41.71 -18.18 -16.25
$/IDR 9395.00 9191.20 9495.27 -2.17 1.07 EUR/IDR 14002.30 10976.11 11334.38 -21.61 -19.05
$/PHP 46.61 53.62 53.57 15.04 14.93 EUR/PHP 69.47 64.03 63.94 -7.83 -7.95
USD TWI 211.49 -11.96 USD TWI 211.49 -11.96
* Adjusted currencies: CZK, HUF, TRY, HKD, PEN, TWD, MYR, BRL, CNY, * Adjusted currencies: CZK, HUF, TRY, HKD, PEN, TWD, MYR, BRL, CNY,
Source: GS Global ECS Research Source: GS Global ECS Research

$/TRY. The ‘fair value’ of the Lira has strengthened, $/CNY. The ‘fair value’ of the $/CNY rate has gained
correcting the previous overvaluation of over 60% to enough strength to align it with the current spot,
around 30%. This is more in line with our bullish stance correcting the previous overvaluation. China is where the
on Turkey’s current growth story and its long-term focus on non-agricultural output has made the biggest
potential as part of the N-11. The Turkish Lira ‘fair difference, as a very large part of the population remains
value’ has also benefited substantially from the employed in the agricultural sector. One fact often
adjustment procedure. forgotten is that China remains a very poor country on a
per-capita basis. If we were to include the vast but poor
$/HKD, $/TWD and $/MYR. The re-estimation and agricultural population in our adjustment model, the
adjustment have strengthened the ‘fair values’ of these CNY would look substantially overvalued currently. On
Asian currencies, contributing further to their current the other hand, the highly productive export sector could
undervaluation. Of the three, the $/HKD rate has seen the probably live with a stronger CNY, as also illustrated by
most substantial change, linked to Hong Kong’s China’s pace of reserve accumulation. Overall, the CNY
relatively high GDP per capita, which has translated into therefore looks too strong for parts for the Chinese
a relatively large adjustment factor. The $/MYR is also economy and too weak for others. Thus, a GSDEER ‘fair
one of the ‘cheapest’, probably consistent with a very value’ estimate that puts ‘fair value’ close to current spot
large current account surplus. sounds about right. It also highlights the need for more
domestic rebalancing in China.

Chapter 1 6 October 2009

Goldman Sachs Global ECS Research The Foreign Exchange Market

$/SGD. The $/SGD has gained considerable strength, Conclusion: GSDEER Model Further Improved
switching from an overvaluation of over 16% to an The latest round of GSDEER model maintenance
undervaluation of around 18%. This is an extreme move incorporated two major changes:
but remains well within the magnitude of misalignment
seen in other crosses and through time. Moreover, an The re-estimation of coefficients with more data led to
undervalued $/SGD is far more consistent with the a reduced sensitivity to commodity prices via the ToT
extremely large and stable current account surplus variable.
position in this managed currency regime.
We have introduced a test-based fixed effect
$/BRL, $/PEN and $/ARS. These three Latin American adjustment procedure for all countries that reveal
countries have seen the ‘fair values’ of their exchange certain data or estimation issues. So far this procedure
rates weaken post re-estimation and adjustment. The had only been applied to CEE countries.
$/BRL is even more ‘expensive’ than before, and is now
the most overvalued currency in our list of specially The resulting changes are broadly in line with
adjusted currencies. However, it is important to remember expectations and ‘fair value’ estimates do not change
that Brazil is one of the world’s least open economies. dramatically in many cases, in particular for freely
External trade accounts for a disproportionally small share floating major currencies with long data histories.
of GDP, so the cyclical impact of either an over- or
undervalued currency is quite limited. In EM space and for commodity-exposed currencies, we
have seen more substantial changes but in general they
The $/ARS undervaluation has been corrected through the were in the direction of what our intuition would have
adjustment, bringing the ‘fair value’ more in line with the suggested. For example, a notable undervaluation for the
current spot, although it still looks to be the ‘cheapest’ $/SGD is more consistent with the large structural trade
currency in the group. The $/PEN has switched from being surplus than our previous estimate of a currency that was
almost in line with its fair value to being significantly broadly ‘fairly valued’.
‘expensive’, and is now one of the most overvalued
currencies in Latin America. Brazil and Turkey have the most overvalued currencies,
consistent with the fact that they are also among the
highest-yielding currencies globally. In terms of the
Summary of Non-Adjusted GSDEER Estimates cyclical position, Brazil has proven a lot more resilient to
As we discussed above, the re-estimation of ‘fair value’ the global recession than most other countries and, from a
should not materially affect the well-behaved crosses for growth differentiation point of view, this alone warrants a
which our test suggests an adjustment is not necessary. currency that trades substantially stronger than ‘fair
Indeed, the fair values of the EUR, JPY, GBP, SEK, CHF value’. We are therefore not concerned about a sudden
and CAD have barely changed. sell-off, although further appreciation may be limited.
On the other hand, we do see some changes in the re- The RUB is also one of the more overvalued currencies
estimated ‘fair values’ of commodity-exposed currencies. against the Dollar, although it remains slightly
Because of the declining coefficient on terms of trade, undervalued vis-à-vis the Euro.
exporting countries have seen their ‘fair value’ revised
down from generally high levels. That said, importing As before, the EUR and the JPY are also substantially
countries, which have seen their ‘fair value’ decline overvalued against the USD. The Dollar remains
rapidly on rising commodity prices in recent years, have significantly undervalued on a trade-weighted basis and
been re-adjusted to a slightly stronger level. As we against most currencies on a bilateral basis. On the other
pointed out above, this pattern was in line with what we hand, the Euro is overvalued against all but a handful of
expected given the huge rise in commodity prices since high-yielding currencies, such as the TRY, BRL and HUF.
the previous re-estimation.
The ‘cheapest’ currencies are the SEK, NOK and SGD.
The Australian Dollar is a good example of this terms of The latter two effectively have managed exchange rates
trade related change, as its ‘fair value’ has been revised and sovereign wealth funds with rapidly growing
down from 0.91 to 0.80 in the re-estimated model. reserves; therefore any substantial move back to ‘fair
Similarly, we have seen the ‘fair value’ in other value’ would be conditional on a policy change.
commodity exporters weaken, such as the MXN, NZD,
ZAR, CLP and VEB. Importing countries, such as Japan, As before, the CNY is about ‘fairly valued’ against the
have at the margin seen their ‘fair value’ strengthen. Dollar but undervalued against most other major
However, many other commodity-importing countries in currencies.
Asia and CEE were among those needing adjustment, and
hence it is less obvious how the impact from a declining Thomas Stolper, Anna Stupnytska and Malachy Meechan
ToT coefficient compares with the impact from the PPP-
based level adjustment.

Chapter 1 7 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

1.4 Australia New
Australia Prior
1.2 AUD
2.0 1.0

1.5 Argentina New

Argentina Prior
0.5 0.6

2Q98 3Q00 4Q02 1Q05 2Q07 3Q09 0.4
1Q74 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09
Source: GS Global ECS Research
Source: GS Global ECS Research


4.0 1.6

3.5 Brazil New 1.5

3.0 Brazil Prior 1.4
2.5 BRL
2.0 1.2
1.5 1.1 Canada New
1.0 Canada Prior
0.5 CAD
1Q94 1Q97 1Q00 1Q03 1Q06 1Q09
1Q74 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09
Source: GS Global ECS Research Source: GS Global ECS Research


2.3 800

2.2 700
Switzerland New
2.1 600
Switzerland Prior
CHF 500
1.8 400
Chile New
1.7 300
Chile Prior
200 CLP
1.3 0
1Q74 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09 2Q83 3Q86 4Q89 1Q93 2Q96 3Q99 4Q02 1Q06 2Q09

Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 1 8 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market


10.0 3000

9.0 2500 Colombia New

Colombia Prior
8.0 2000

7.0 1500

China New
6.0 1000
China Prior
5.0 CNY 500

4.0 0
4Q87 2Q90 4Q92 2Q95 4Q97 2Q00 4Q02 2Q05 4Q07 2Q10 1Q80 2Q83 3Q86 4Q89 1Q93 2Q96 3Q99 4Q02 1Q06 2Q09

Source: GS Global ECS Research Source: GS Global ECS Research


40.0 1.6

35.0 1.4

30.0 1.2

25.0 1.0

20.0 Czech Republic New 0.8 EURO New

Czech Republic Prior EURO Prior

15.0 0.6

10.0 0.4
1Q95 1Q97 1Q99 1Q01 1Q03 1Q05 1Q07 1Q09 1Q81 3Q84 1Q88 3Q91 1Q95 3Q98 1Q02 3Q05 1Q09

Source: GS Global ECS Research Source: GS Global ECS Research

UK New 10.0
UK Prior
2.0 GBP

1.8 6.0

1.6 4.0 Hong Kong New

1.4 Hong Kong Prior
2Q81 2Q86 2Q91 2Q96 2Q01 2Q06
4Q74 4Q79 4Q84 4Q89 4Q94 4Q99 4Q04 4Q09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 1 9 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Indonesia New
300 10000.0
Indonesia Prior
250 8000.0
200 Hungary New 6000.0
Hungary Prior
150 4000.0
100 2000.0

1Q83 1Q88 1Q93 1Q98 1Q03 1Q08
2Q96 3Q98 4Q00 1Q03 2Q05 3Q07 4Q09
Source: GS Global ECS Research Source: GS Global ECS Research

5.0 60.0
50.0 India New
4.4 India Prior
4.2 INR

4.0 30.0
3.6 Israel New

3.4 Israel Prior 10.0

3.2 ILS

3.0 0.0
1Q80 1Q85 1Q90 1Q95 1Q00 1Q05 1Q10
2Q96 3Q98 4Q00 1Q03 2Q05 3Q07 4Q09
Source: GS Global ECS Research Source: GS Global ECS Research


Japan New South Korea New
250 1400
Japan Prior South Korea Prior
200 1200 KRW

150 1000
100 800
1Q74 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09
2Q80 2Q85 2Q90 2Q95 2Q00 2Q05 2Q10
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 1 10 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market


14.0 Malaysia New

Mexico New 4.0 Malaysia Prior
12.0 Mexico Prior MYR

10.0 MXN 3.5


4.0 2.5

3Q83 3Q88 3Q93 3Q98 3Q03 3Q08
2Q85 2Q88 2Q91 2Q94 2Q97 2Q00 2Q03 2Q06 2Q09
Source: GS Global ECS Research Source: GS Global ECS Research


10.0 1.4

9.0 1.2 New Zealand New

New Zealand Prior
1.0 NZD
Norway New 0.6
Norway Prior
NOK 0.4

3.0 0.2
1Q74 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09 1Q74 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09
Source: GS Global ECS Research Source: GS Global ECS Research


4.5 60.0
3.0 40.0

Peru New
2.0 Philippines New
Peru Prior 20.0
1.5 Philippines Prior
1.0 PHP
0.0 0.0
1Q91 3Q93 1Q96 3Q98 1Q01 3Q03 1Q06 3Q08 1Q83 2Q86 3Q89 4Q92 1Q96 2Q99 3Q02 4Q05 1Q09

Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 1 11 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market


5.0 45.0
4.5 Russia New
35.0 Russia Prior
4.0 30.0 RUB
Poland New
3.0 15.0
Poland Prior
2.5 PLN
2.0 0.0
4Q95 4Q97 4Q99 4Q01 4Q03 4Q05 4Q07 4Q09 1Q95 1Q97 1Q99 1Q01 1Q03 1Q05 1Q07 1Q09
Source: GS Global ECS Research
Source: GS Global ECS Research


12.0 2.4
2.2 Singapore New
Singapore Prior
9.0 SGD
8.0 1.8

7.0 1.6
Sweden New 1.4
Sweden Prior
4.0 SEK
3.0 1.0
1Q74 1Q79 1Q84 1Q89 1Q94 1Q99 1Q04 1Q09 1Q80 2Q83 3Q86 4Q89 1Q93 2Q96 3Q99 4Q02 1Q06 2Q09
Source: GS Global ECS Research Source: GS Global ECS Research


50.0 3.0

45.0 2.5 Turkey New

Turkey Prior
2.0 TRL
Thailand New 1.5
Thailand Prior 1.0
20.0 0.5

15.0 0.0
2Q83 3Q86 4Q89 1Q93 2Q96 3Q99 4Q02 1Q06 2Q09 4Q95 4Q97 4Q99 4Q01 4Q03 4Q05 4Q07 4Q09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 1 12 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market


50.0 4.0

Taiwan New 3.5 Venezuela New

Taiwan Prior 3.0 Venezuela Prior
2.5 VEF
35.0 2.0

20.0 0.0
1Q80 2Q83 3Q86 4Q89 1Q93 2Q96 3Q99 4Q02 1Q06 2Q09 1Q83 2Q86 3Q89 4Q92 1Q96 2Q99 3Q02 4Q05 1Q09
Source: GS Global ECS Research Source: GS Global ECS Research



10.0 South Africa New

South Africa Prior
8.0 ZAR




1Q80 2Q83 3Q86 4Q89 1Q93 2Q96 3Q99 4Q02 1Q06 2Q09
Source: GS Global ECS Research

Chapter 1 13 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chapter 2: Using GSDEER to Trade Equities

Our GSDEER current valuation tool provides an important signal not just for relative FX returns but for
equities too. Since real currency misalignments can be resolved through local prices as well as through nominal
currency shifts, we have always suspected this might be the case. It is striking, though, that the Sharpe ratio
from using GSDEER to trade equities in common currency is better than it is for FX, suggesting that those
allocating across equity indices may want to pay more attention to currency valuation than they often do.

Currency Valuation as a Guide to Real Misalignments There are commonly cited intuitive reasons for thinking
We have shown on many occasions over the past decade that countries with undervalued currencies may have
or so how our GSDEER currency valuation models help better equity performance. Those with undervalued
to predict forward FX returns, particularly over long currencies may see stronger export-led growth—a notion
horizons. We described our GSDEER currency valuation we have exploited from time to time when
model in more detail in Chapter 1, where we re-estimated recommending equity markets where financial conditions
the latest version. Although convergence on ‘fair value’ are easier. And when countries resist appreciation in
in FX markets is relatively slow, we pay a great deal of undervalued currencies, the result is often a liquidity
attention to the signals from GSDEER in trading FX, injection into the local economy and asset markets that is
particularly when currencies are a long way from reflationary. But these channels are really examples of
equilibrium and when the market itself appears to be in how the basic real adjustment process can take place, not
the process of focusing on imbalances, as it has done over separate dynamics.
the past 12 months.
We look here at whether those equity markets whose
Because of this convergence to ‘fair value’, the strategy currencies are undervalued on the basis of GSDEER tend
of being long the most undervalued currencies and short to outperform those with more overvalued currencies
the most overvalued—which is what our FX Valuation over time. We find that FX valuation seems to provide a
Current1 (formerly FX Valuation Slice) essentially good signal for relative equity, as well as FX,
captures—tends to be profitable on average over time, performance, as theory would predict. What is even more
although there are many specific periods when it is not. striking is that using GSDEER to guide investment in
And the Valuation Current rises over time, delivering an equity indices in common currency to capture both the
average annual return of around 3.6% since 1998 and FX and relative index performance seems to deliver
7.5% over the last 12 months. higher Sharpe ratios for FX than using it for equity alone.

We have long been aware that a real exchange rate

A Higher Sharpe Ratio Using GSDEER to Trade
misalignment such as those signalled by GSDEER can be
resolved in one of two ways: by a nominal exchange rate Equities/FX Together
adjustment or by a shift in the relative domestic prices of To look at this issue, we start by replicating the
goods and services, and hence through local asset prices— methodology of the FX Valuation Slice in equities. We
or some combination of the two. As a result, focusing take a universe of 20 reasonably liquid international
only on the FX implications potentially misses part of the equity indices (Table 1). We again use GSDEER to
adjustment and the opportunity, particularly where Index Chart 1: Historical Performance of Equity
currencies are heavily managed. Given that many
(USD), Equity (Local Ccy) and FX Slices
emerging market (EM) exchange rates are still a long way 380
360 Equity Slice (USD)
from being free-floating, that problem can be particularly
acute: it may be possible to identify a significantly 320
Equity Slice (Local Currency)
undervalued exchange rate (as at times in the past few 300 FX Slice
years with the CNY) but harder to benefit from that view 280
in FX markets than for a truly floating currency. Local 260
asset prices (equities) may adjust instead.
Table 1: Our Universe of 20 Countries
Australia Hong Kong Poland Sweden 160
Brazil India Russia Switzerland 140
Canada Japan Singapore Taiwan 120
China Mexico South Africa Turkey 100
EMU Norway South Korea United Kingdom 80
Source: GS Global ECS Research 98 99 00 01 02 03 04 05 06 07 08
Source: GS Global ECS Research, MSCI International Equity Indices

1. Although the FX Valuation Slice is a predecessor of the investable GS FX Valuation Current, technically these two products are slightly different
from the weighting methodology and the USD component inclusion perspectives. For more information on GS FX Currents, please see Global
Viewpoint 09/12 “‘FX Slices’ Become New Tradable ‘FX Currents’”.

Chapter 2 14 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

identify the markets with the six most overvalued and Table 3: Panel Regressions: 1m & 6m Fwd Returns as a
Function of Currency Misvaluations
undervalued currencies, but using the total return series
Fwd Return R-
based on the relevant MSCI indices, we now look at Horizon
Intercept Beta T-Stat
going long and short their equity markets. We look at this EQ Slice 1-month 0.83 -0.03 -2.73 0.3%
on a ‘currency unhedged’ basis (where the investments USD 6-month 4.08 -0.07 -1.02 0.3%
essentially benefit from both FX and local equity market EQ Slice 1-month 0.82 -0.02 -1.62 0.1%
appreciation), which is what the theory suggests is the Local Ccy 6-month 4.16 0.00 -0.03 0.0%
most logical instrument. But we also construct a version Source: GS Global ECS Research, MSCI International Equity Indices
that looks only at local currency equity returns and a
matching version of our FX Slice for this specific past for GSDEER itself. Specifically, we used a panel
universe, which allows us to decompose the overall regression to attempt to explain 1- and 6-month forward
return effectively into its equity and FX components. returns as a function of GSDEER misvaluations over our
sample period. Table 3 displays the statistical results of
Chart 1 illustrates the performance of the three indices these regressions. In all cases, even at this very short
created along these lines (equities in USD, equities in horizon, GSDEER is statistically significant in predicting
local currency and FX). All three trend upwards over both the USD and local currency equity returns, although,
time, suggesting that the convergence to FX valuation as is usual with these kinds of tests, the amount of overall
does help in determining cross-country equity variation it helps to explain is extremely low. This is why
performance. The highest returns over time come from diversified strategies work better and why long-term
the USD equity strategy, followed by local currency performance is more reliable than shorter-term.
equities and then FX returns. The decomposition
indicates that the USD equity strategy benefits from both
the impact on currency returns and the impact on local Are We Picking Up Something Else?
currency equity performance. We are wary of the possibility that in using GSDEER, we
are unintentionally picking up exposure to some other
The volatility of the underlying assets does, of course, factor (such as market risk, etc.) that would help explain
differ substantially. That said, a comparison of a basic why returns are positive over time.
version of the Sharpe ratio (returns divided by realised
volatility) in Table 2 shows that the USD equity strategy To cross-check against that risk, we look at the
is the most reliable of the three combinations on that correlations between the three versions of the strategy
front too, at least over the last 11 years since data have (USD equity, local currency equity, FX) and a range of
been easy to obtain. Both the FX and local currency other macro asset measures that may conceivably be
equity components alone deliver inferior (and driving the results. We find that the USD equity and local
comparable) Sharpe ratios, although both are positive currency equity indices are highly correlated with each
over time. Each strategy has periods of superior other, and that the USD equity index is also well
performance and periods of weakness; hence, for shorter- correlated (albeit less so) with the FX index. This is
term trading it remains helpful—when possible—to probably largely a reflection of the relative volatility of
identify periods when valuation is and is not a market the two assets.
driver. But the USD equity index has had only two
What is more interesting is that the local currency equity
negative years in our sample, compared with four for
index and the FX index have almost zero correlation with
each of the other two components.
each other. As a result, the equity and FX components of
To validate the notion that GSDEER matters for returns returns do appear to be picking up generally different
in the way the strategy suggests, we also tested the kinds of convergence.
predictive power more formally, as we have done in the
Table 2: Sharpe Ratios, Returns and Standard Deviations for Equity (USD), Equity (Local Ccy) and FX Slices
Sharpe Ratio Return (Ann.) Stardard Deviation (Ann.)
Eq Slice Eq Slice Eq Slice Eq Slice Eq Slice Eq Slice
Year FX Slice FX Slice FX Slice
(USD) (Local Ccy) (USD) (Local Ccy) (USD) (Local Ccy)
1999 2.1 0.9 3.3 40% 16% 21% 19% 18% 6%
2000 1.4 1.5 -1.2 27% 29% -8% 19% 19% 7%
2001 1.2 1.4 -0.1 22% 25% -1% 19% 17% 10%
2002 0.8 -0.5 1.9 12% -7% 13% 15% 12% 7%
2003 0.3 -0.5 1.7 4% -5% 9% 13% 11% 5%
2004 0.7 0.5 0.3 8% 5% 2% 11% 10% 5%
2005 -0.7 -1.5 0.9 -7% -13% 4% 9% 9% 4%
2006 1.3 1.8 -1.0 15% 18% -4% 12% 10% 4%
2007 -0.5 -0.2 -1.5 -6% -2% -7% 14% 14% 5%
2008 0.9 0.6 0.7 19% 11% 5% 20% 18% 7%
2009 0.6 0.1 0.7 8% 1% 6% 13% 12% 9%
Overall 0.8 0.5 0.6 13% 7% 4% 15% 14% 7%
Source: GS Global ECS Research, MSCI International Equity Indices

Chapter 2 15 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Table 4: Returns Correlations for Equity (USD), Equity (Local Ccy) & FX Slices and Macro Factors
Correlations of 1-week Returns Correlations of 2-week Returns
Eq Slice (Local Eq Slice (Local
Eq Slice (USD) FX Slice Eq Slice (USD) FX Slice
Ccy) Ccy)
Eq Slice (USD) 100% 85% 47% 100% 84% 46%
Eq Slice (Local Ccy) 85% 100% 4% 84% 100% 0%
FX Slice 47% 4% 100% 46% 0% 100%
Oil 5% 3% 4% -7% -3% -8%
10-year Yields 1% -1% 6% -1% -5% 8%
SPX -1% -5% 1% 2% -3% -3%
USD TWI 7% 9% 1% 12% 10% 12%
VIX 4% 3% 8% 0% 4% 5%
WF Growth 12% 9% 3% 8% 7% -4%
WF China 3% 3% 0% 4% 5% -12%
WF Cons. Growth -2% -5% 0% -4% -7% 0%
WF Foreign 10% 11% 1% -1% 0% 1%
WF Housing -8% -11% 3% -15% -15% -1%
WF Oil -4% -5% 0% -11% -4% -13%
WF Oil Growth -4% -2% 1% -10% -3% -9%
WF Rates 9% 4% 10% -1% -3% 2%
WF Turbo Growth 11% 7% 3% 12% 9% -2%
Source: GS Global ECS Research, MSCI International Equity Indices

We checked the correlation of each index (in 1- and 2- By taking into account relative volatilities and betas in
week returns) with: terms of equity selection.

SPX and VIX – to measure market risk. By taking account of equity valuations as well as
currency valuations. In particular, we would like to see
Oil – to see if we are picking up a commodity proxy. whether equity valuations are more or less useful than
FX valuations as a determinant of cross-sectional
Our Wavefront Growth basket in equities – to see if returns.
we are picking up cyclical risk.
By looking at whether different thresholds matter in
10-year yields – to gauge rates exposure and cyclical terms of identifying the valuation signal.
It would also be helpful to understand more about what
The USD TWI – to see if we have a closet Dollar view characterises those periods when the strategy works
embedded in this method. better and those when it works less well. Is this a function
of when valuation dispersion is less extreme, so that
Overall, the results (Table 4) show extremely low ranking on a signal is less effective? Or is it a function of
correlations to all of these factors (in general, less than growing global imbalances that are tending to drive
15% in absolute terms). So whatever we are capturing currencies away from ‘fair value’, as we saw in 2007 for
here seems to be a genuinely independent source of instance, when currencies moved particularly strongly
return, not an accidental linkage with some other source against their valuation signals?
of risk. This is encouraging too, although it raises the
challenge of identifying those moments when valuation is A preliminary look at these issues provides promising
likely to be particularly strongly rewarded and those results, which deserve to be studied in more detail. We
when it is not, as is also the case with our Valuation compared the returns on our strategy to both the
Current in FX. dispersion of misvaluation and the average gap in
misvaluation between longs and shorts. Both are simple
We also looked at how often the composition of the measures of how ‘strong’ the valuation sorting signal
basket changes. The answer is that there is roughly a 10% actually is. We do find—as the charts on the next page
chance in a given month that a member on the long or
short side is replaced, so the baskets are reasonably stable Table 5: Current Constituents (October 2009)
over time, consistent with the relatively slow-moving
Undervalued (Long) Overvalued (Short)
system that generates them.
Country Weight Country Weight
Hong Kong 16.7% Brazil 16.7%
Looking Forward—A Fruitful Area Given Low Focus India 16.7% EMU 16.7%
from Equity Investors Mexico 16.7% Japan 16.7%
The basic insight opens up a number of avenues. We Norway 16.7% Singapore 16.7%
would like to understand more about whether the simple South Africa 16.7% Switzerland 16.7%
notion can be improved into a more effective strategy. Taiwan 16.7% Turkey 16.7%
Source: GS Global ECS Research
This can be done in a number of ways:

Chapter 2 16 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Equity Slice Equity Slice

Chart 2: Dispersion of Currency Misvaluation Chart 3: Dispersion of Currency
(USD) 1yr (Local Ccy)
Fw d Return
vs 1-year Fwd Returns of Equity (USD) Slice 1yr Fw d Misvaluation vs 1-year Fwd Returns
Return of Equity (Local Ccy) Slice
y = -0.03 + 0.84x 30%
y = -0.03 + 0.55x
25% R2 = 10% 25%
R2 = 5%
20% 20%

15% 15%
-5% Dispersion of Currency -10%
Misvaluation Dispersion of Currency Misvaluation
-10% -15%
5% 10% 15% 20% 25% 30% 5% 10% 15% 20% 25% 30%
Source: GS Global ECS Research, MSCI International Equity Indices Source: GS Global ECS Research, MSCI International Equity Indices

show—that returns from the strategy are highest on

average after periods when valuation dispersion has been
high and so currencies are in very different places to
where they ‘belong’. This suggests we may be able to
refine the signals according to how strong they are.

Consistent with this observation, the performance so far

this year is striking after a period of unusually high
deviations from ‘fair value’. Across all three strategies,
2009 has been a year in which valuation has had strong
predictive power, and the second half of 2008 had similar
features. The unwinding of global imbalances and
dislocations that we have documented over the past 12
months appears to have been a powerful force in driving
currencies and other assets back towards ‘fair value’. It is
equally clear that, in the process, both equities and FX—
and even more so a combination of the two—have been
rewarded by paying attention to GSDEER.

Dominic Wilson and Roman Maranets

FX Slice 1yr Chart 4: Dispersion of Currency Misvaluation

Index Chart 5: Year-To-Date Performance of Equity
Fw d Return vs 1-year Fwd Returns of FX Slice (USD), Equity (Local Ccy) and FX Slices
20% 1.12
y = -0.01 + 0.21x
R2 = 1% 1.1
5% 1.04

0% 1.02

-5% EQ Slice USD
0.98 EQ Slice Local Ccy
Dispersion of Currency Misvaluation
-10% FX Slice
5% 10% 15% 20% 25% 30%
Jan-09 Mar-09 May-09 Jul-09 Sep-09
Source: GS Global ECS Research, MSCI International Equity Indices
Source: GS Global ECS Research, MSCI International Equity Indices

Chapter 2 17 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chapter 3: Measuring Global Output Gap Dispersion as a Guide

for Relative Growth Strategies
In this chapter we try to identify the stage of the business cycle at which growth differentiation strategies reap
the most returns for FX. We find broad evidence that differentiation strategies start to outperform when
economies are emerging from the troughs of the cycle. More specifically, the key is to identify when output gaps
are at their most dispersed across countries. This dispersion creates the most scope for exchange rates to help
redistribute excess capacity across countries, given their role as a measure of relative prices. Our research
suggests that growth differentiation strategies tend to underperform as we approach the peak of the global
business cycle, where growth differentiation gradually disappears.

Output Gaps Matter for FX performance1 which encourages more imports to free up even more
Economics theory can provide reasonable explanations resources for the booming export sector. Compared with
for the relationship between output gaps and FX. For the standard Mundell-Fleming model (in which a
example, we can take the approach of a Mundell-Fleming country’s export sector competes with foreign producers),
open economy framework, where the exchange rate, as this special case assumes complementarities between
an expression of relative prices, is the facilitating exporters and foreign producers.
mechanism in the reallocation of resources across
countries. Faster growth and capacity constraints shift the In practice, the central bank reaction function is also an
demand curve out, leading to a rise in prices and a rising important factor in the transmission from output gaps into
domestic interest rate. The resultant appreciating FX. Where capacity constraints lead to inflationary
pressures on the exchange rate act as a redistributive tool, pressures, tighter monetary policy and appreciating
and the impact on a country’s trade flows (lower exports currencies follow—either through market forces such as
and higher imports) eventually rebalances demand across carry, or through explicit FX management, as in many
countries over time. Asian countries. Another possible channel is through
capital inflows. Stronger growth prospects boost
A caveat to this simple framework is that the domestic investment opportunities and attract the inflow of capital,
cycle of some countries may be highly geared to the which also drives FX appreciation.
global cycle, with a beta greater than one, i.e., these
countries mainly have externally-driven domestic cycles. While the theoretical underpinnings are straightforward,
Growing external demand may lead to an even greater it is not clear if it is the change in or level of the output
increase in domestic demand and a stronger currency, gap that matters. It is also unclear whether global or local

Summary Table of Regression Results: Changes in Domestic Output Gaps Matter Most, Especially for EM Countries
Domestic OP Gap Global Output Gap
(Coeffecients, t-stat) Domestic OP Gap Level Global OP Gap Level R-sq
Change Change
AUD √ (1.7, 1.6) 0.27
NZD 0.44
SEK 0.43
CAD √ (1.8, 3.9) √ (3.7, 3.8) 0.65
GBP √ (3, 2.5) 0.45
CHF 0.29
JPY 0.41
NOK 0.33
USD 0.26
CNY √ (1.95, 2.03) 0.37
INR √ (2.18, 2.43) 0.50
IDR √ (4.94, 5.16) 0.66
KRW √ (1.22, 2.68) √ (2.40, 2.42) 0.69
MYR √ (0.80, 2.29) 0.63
MXN √ (3.18, 2.88) 0.59
PHP √ (2.63, 3.49) √ (5.63, 1.8) 0.53
SGD √ (0.29, 1.78) 0.68
TRY √ (1.91, 2.4) 0.47
TWD √ (1.18, 1.77) √ (2.34, 2.09) 0.45
THB √ (0.6, 4.26) 0.74
Source: GS Global ECS Research

1. This section provides a recap of our previous work on the links between output gaps and FX (see Global Viewpoint 09/13, “Focusing on Output
Gaps—A Guide to FX Differentiation in the Recovery Cycle”, August 12, 2009).

Chapter 3 18 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Change In Output Gaps Drives FX Returns Mexico: TWI Returns vs Output Gap Change
Over Cycles, Especially for Small Open %
Since 1981
Economies—Example of Mexico
8 10 15 Nominal TWI
6 0 returns (%)
-10 5
2 OP gap change (%)
-20 0
-2 -30 -5
-4 -10
Change in output -40
-6 gap from year ago -15
-8 -20
nominal TWI returns
-10 -60
(RHS) -25
-12 -70
-14 -12 -10 -8 -6 -4 -2 0 2 4 6
Source: GS Global ECS Research Source: GS Global ECS Research

output gaps matter more. We have attempted to define Which part of the cycle best rewards growth
the relationship empirically: we performed a regression differentiation for FX?
analysis, running trade-weighted FX returns against the Having pinned down the relationship between output
levels of and changes in both domestic and global output gaps and FX, we then identified the periods of the cycle
gaps, and controlling for certain exogenous factors (see that provide the most fertile ground for growth
the box at the end of this chapter for further details on the differentiation strategies to take root.
exact specification).
A cursory look at the performance of our output gap
The table on the previous page summarises the results of differentiation basket (we constructed a basket of
our regressions: a positive result indicates that the currencies grouped according to differences in output
variables of domestic or global output gaps are gaps) reveals years of good performance following
statistically significant (we have included the coefficient periods of stalled performance, as seen in the chart below.
of the variable in question, followed by its t-statistic in A closer look at the series seems to show a relatively good
brackets). Our three main findings are as follows: correspondence with the boom/bust fluctuations through
the cycles. For example, the index shows mixed
The changes in output gaps are more important for FX
performance during the height of the tech bubble years in
performance than the absolute levels of the gap.
the early part of this decade. This was followed by returns
The local output gap tends to matter more than the of around 30% from 2002 to 2005 as the global economy
global output gap. emerged from the troughs of the ‘dot com’ bust and
steadily grew from there. However, as we approached the
These results are better reflected in emerging market peak of the cycle, the index stalled again. The index did
economies, which are typically small open economies, not start to show signs of life again until after we emerged
providing the most scope for exchange rates to act as a from the troughs of the most recent crisis.
redistributive tool of excess capacity.
Measuring the dispersion of output gaps worldwide.
Output Gap Differentiation Basket Shows
The observations described above seem to imply that the
Interesting Differential Performance scope for FX as a redistributive tool is the greatest when
Corresponding to Stages of the Cycle the dispersion of output gap changes is the greatest across
120 countries. This would logically concur with the period
115 around the troughs of a global recession and during the
M ixed ensuing stages of recovery, when there are differences in
110 perfo rmance in
the do t co m the pace of recovery across countries. It is not until later
105 'bo o m' phase in the business cycle, closer to the peak, when economies
are all growing at maximum capacity, that we see little
Under- Outperfo r dispersion in the speed at which output gaps narrow. The
95 Outperfo rmance in
perfo rmance mance charts on the next page show the changes in output gap in
during the glo bal emerging
the po st bubble credit 'bo o m' fro m the 2009 and in 2007: we see little dispersion in 2007 when
90 burst reco very years tro ughs all economies were close to their peak and ‘overheating’,
85 while 2009 shows economies during the trough of the
business cycle with very large differences in the pace at
99 00 01 02 03 04 05 06 07 08 09 10 which the output gap widens. This in turn sets the stage
Source: GS Global ECS Research for differences in the pace of subsequent output gap

Chapter 3 19 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Changes in Output Gaps: Least Dispersion at …And Most As We Emerge From

the Peak of the Cycle (2007)... the Troughs (2009)
11 1
10 0
9 -1
8 -2
7 -3
6 -4
5 -5
4 2007 -6
3 -7 2009
2 -8
1 -9
0 -10
-1 -11









































Source: GS Global ECS Research Source: GS Global ECS Research

narrowing during the recovery. Growth differentiation returns in our output gap FX basket (see chart below).
strategies seem to work best during this latter stage. Specifically, FX returns appear to be high when output
gap dispersion is also high, which in turn corresponds to
To arrive at a measure of dispersion of output gaps across the periods when the global economy emerges from
countries, we take the standard deviation of the output recession, as we showed in the previous section.
gap changes across the different countries for any given
year. This measure of output gap dispersion has a fairly The same can be shown more formally through a simple
good inverse correlation with global GDP growth (see linear regression. We find a rather tight relationship with
chart below). And it lends support to our earlier an R-squared of 0.7, as can be seen in the chart on the
reasoning that output gaps are at their most dispersed next page. This regression also reveals that a dispersion
across countries when the world is emerging from the of global output gap changes of more than 1.6 standard
trough of a business cycle and, conversely, are least deviations typically results in positive returns for our
dispersed close to the peak of the cycle. output gap FX basket.

FX growth differentiation strategies outperform when We currently expect an output gap dispersion of around
output gaps most dispersed across countries. Having 2.9 standard deviations for 2009, which is well above the
established the links between the business cycle and level that would normally result in positive FX returns,
output gap dispersion, we can now return to our initial and implies great scope for FX trades based on growth
hypothesis that FX growth differentiation provides the differentiation strategies into 2010 and beyond. Indeed,
best returns during the early stages of a recovery. our Growth Current—the tradable version of a basket of
currencies differentiated in practice according to
We find that a good relationship exists between the variations in the output gap—has started to outperform,
dispersion of output gap changes and 1-year lagged after months of stalled performance.

Output Gaps Are Most Dispersed Dispersion in Output Gaps Across Countries
Std Dev % chg yoy % Std. Dev
Emerging From Cycle Troughs Drive FX Returns
3.5 -2.0 10 3.5
Measure of output gap
dispersion across the -1.0 8
3 w orld 3
w orld GDP grow th 6
2.5 (Inverted RHS) Increasing 1.0 2.5
output gap 4 2009 YTD
dispersion 2.0 returns
2 2 2
1.5 4.0 1.5
5.0 -2
1 1
6.0 -4 OP gap basket returns (lagged 1 year)
OP gap dispersion (RHS)
0.5 7.0 -6 0.5
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 3 20 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

The Impact of the Output Gap on FX—Our Methodology

We attempt to test the relationship between output gaps SPX is the S&P 500 index, intended to capture
and FX. We calculate the output gap as the difference underlying risk sentiment and the impact on FX; GSCI
between real actual GDP over potential GDP, expressed is the Goldman Sachs Commodity index included to
as a ratio of potential GDP. To obtain a consistent account for the link between commodity prices and
measure of output gaps across countries, we have currencies, important for commodity currencies in
estimated potential GDP here using the Hodrick and particular; the TWIs are the GS trade-weighted
Prescott filter, a simple statistical procedure. This is just exchange rates and we have included the Dollar TWI as
one of various ways to estimate a country’s trend GDP. a RHS variable to account for currency moves driven by
The purpose of our discussion here isn’t to establish the broad Dollar moves. We ran these regressions for
best technique for estimating potential growth or to countries where we have sufficient data across the G10
replace the more formal models that we have for some and emerging markets. The sample period for this runs
individual countries. But rather to subject each country from 1981 to 2008.
to a consistent method of estimation and in so doing
obtain a ranking for relative FX performance. Note that we used real TWIs instead of nominal
exchange rates as the LHS variable. We think the
We ran OLS regressions, looking at the changes in real implications for real TWIs can be mapped onto our
trade-weighted exchange rates versus moves in the nominal exchange rate views given the assumption that
domestic and global output gaps, while controlling for relative inflation differentials should be fairly stable
risk sentiment, commodity moves and broad Dollar over our trade implementation horizon, especially given
moves. We ran our regressions according to the increased and more successful inflation targeting over
following specification: the years.

Equation 1 As a cross-check, we also tried different specifications

of the model, including output gap levels alone, output
∆ Real TWI = α+ β1*LGAP + β2*(LGAP-LGAP(-1)) + gap changes alone, and the changes in output gap as a
β3*GGAP+ β4*(GGAP-GGAP (-1)) + β5* ∆SPX + share of the levels. We find that the specification
β6*∆ GSCI+ β7*∆USD TWI + µ presented above has the ‘best fit’ among the various
specifications and produces results that are largely
where LGAP is the local or domestic OP gap; GGAP is consistent across countries.
the global output gap as proxied by the G7 output gap;

Positive FX Returns When Output Gap

Dispersion Above 1.6 Std. Dev.

Global Output
Gap y = 0.1x + 1.6
2.5 Dispersion R 2 = 0.7
(Std dev)


0.5 % return in output

gap FX basket
-6 -4 -2 0 2 4 6 8 10
Source:GS Global ECS Research

Overall we expect the next couple of quarters to present

attractive opportunities for FX strategies based on
relative growth strategies and, in particular, those that
focus on relative changes in the output gap.

Mark Tan

Chapter 3 21 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chapter 4: The Benefits of Investing in Portfolios of FX Currents

Following the introduction of the new tradable FX Currents to replace our purely analytical FX Slices, we look
at the construction of portfolios of FX Currents with high Sharpe ratios. One key result is that very Sharpe
ratios can theoretically be obtained—even when taking into account indicative trading costs. In addition, certain
FX Currents tend to perform particularly well in certain macro environments. We intend to apply the results of
our analysis when formulating FX strategy and recommendations in the future.

FX Slices Become FX Currents We then look at the composition of these portfolios over
Our FX Currents are based on the FX Slices concept, time to extract lessons on the combinations of tradable
which we introduced four years ago in the 2005 issue of themes that have provided the best returns over the
The Foreign Exchange Market. The purpose of the different stages of the last cycle.
Currents project was to create long-short portfolios of
currencies that were meant to capture the performance of We have identified the relevant patterns in each Current,
a particular macro theme in the FX market. Since then, and these broad patterns should help us formulate our
we have used the Currents to analyse the trading strategy.
environment, assess the potential for different cross-
currency trades to perform (given the market trends), and Portfolios of FX Currents: Combining Themes offers
express our views on the potential future performance of Higher Sharpe Ratios
the different Currents. An FX Current represents a simple approach to
implementing a specific theme in the FX market. For
As we wrote recently (see Global Viewpoint 09/12, July
example, the Growth Current offers a simple benchmark
20, 2009), the FX Currents replace our FX Slices, making
to quantify the market’s preference for high growth
them fully tradable instruments. We have six FX Currents
currencies. To the extent that strong growth is one of the
at present: the G10 & Emerging Markets Carry Current,
key themes driving the FX market, this Current aims to
the BRIC/N-11 Current, the Energy Current, the
Valuation Current, the Growth Current and the Current capture the shifts in this theme.
Account Current. We constantly monitor their However, even from a theoretical perspective, an index
performance for analytical purposes but also intend to use approach (which is what the FX Currents are) is not the
them for our trade recommendations. most pure expression of a theme. This is because
typically a combination of themes drive price action and
Different FX Currents tend to outperform during different
it is difficult to disentangle the individual impact of each
stages of the business cycle. For example, Chapter 3 in this
theme. In that sense, the price action in each Current may
publication shows that the FX Growth Current typically
reflect a set of underlying macro drivers and, vice versa,
posts good returns during early stages of a global recovery.
each theme may have multiple expressions in different
However, beyond focusing on the likely performance of Currents or in different combinations of Currents.
one individual FX Current, it is also important to look at
We have attempted to gauge the overall impact of
the linkages between them. This chapter forms part of this
combinations of different macro themes on the FX
effort. Here, we look at FX Currents from a portfolio
markets in the past. In the 2006 issue of The Foreign
perspective, and examine how individual Currents and
Exchange Market we introduced our ‘Multivariate Slices’
portfolios of Currents have performed over time.
analytical framework, which used rolling cross-sectional
We find that, although some individual Currents (such as regressions to de-compose moves across currencies into
the Carry Current) do offer high Sharpe ratios, combining different factors. Although that approach was not based
Currents in portfolios offers better reward for risk than on tradable macro factors, it did indicate that interest
individual ones, especially if we adjust for trading costs. rates, volatility and Dollar direction were among the most
important drivers of price action in the FX markets.
We also look at ‘optimal’ portfolios of Currents, designed
ex-post to give the highest Sharpe ratios among different In this piece we approach the problem from a new angle.
combinations of Currents (under specified constraints). We combine our tradable FX Currents in portfolios and
try to gauge the returns that combinations of FX themes
Table 1: How to Find FX Currents in Bloomberg can offer.
FX Currents Bloomberg Tickers
To place FX Currents in the context of a broader
G10 & Emerging Markets Carry Index GSCUEMCC Index portfolio of FX indices, it is useful to look first at some
BRIC/N11Core Index GSCUBRIC Index
simple descriptive statistics. Table 2 shows the average
Energy Currencies Index GSCUENER Index
volatilities and returns for different FX Currents over the
Valuation Index GSCUVALU Index
period from 1999 to mid-2009. A first observation is that
Growth Index GSCUGROW Index
most Currents have very comparable volatilities of
Current Account Index GSCUCACC Index
Source: GS Global ECS Research

Chapter 4 22 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Table 2: Historical Risk Reward in Different Currents Table 4: Correlations Across Currents

Average Carry Valuation Growth CA BRIC/N11 Energy Carry Valuation Growth CA BRIC/N11 Energy

Return 7.2% 2.0% 2.3% -1.3% 2.0% 2.0% YLD 100%

Vol 4.3% 3.3% 2.7% 3.3% 3.5% 2.7% VAL -6.4% 100%

S.R. 1.7 0.6 0.8 -0.4 0.6 0.7 GRO 13.4% -2.5% 100%
Source: GS Global ECS Research CA -58.6% 8.1% -13.1% 100%
EM 43.0% 1.4% -15.2% -3.9% 100%
ENER 44.6% 7.3% 21.2% -46.9% -33.5% 100%
between 2.7% and 3.5% p.a.; the exception is Carry, Source: GS Global ECS Research
which is far more volatile than other Currents, with an
average annualised volatility of 4.3%. There is no single year in which portfolios of FX
Currents have yielded negative returns. During years
And while the volatilities of the different Currents are when cyclical pressures have been more supportive
broadly comparable, the average annual returns are towards risk-taking (e.g., 2005-2007), equally-
substantially different, creating disparities among weighted baskets offered better returns relative to
Currents in terms of Sharpe ratios. At one extreme, the volatility-adjusted baskets, as they had more exposure
Carry Current (the FX index that mostly captures global to riskier Currents, and vice versa.
markets’ risk sentiment) has an annualised Sharpe ratio
of almost two, combining the highest volatility with the Overall, it appears that there are diversification benefits
highest average return. At the other extreme, the to holding broader baskets of FX Currents. This should
‘defensive’ Current Account Current exhibits negative also be visible in the correlation structure among
returns and high volatility. Currents. In Table 4 we highlight the correlation in
historical returns between Currents. We focus on the
This simple set of statistics provides further evidence correlations above 30% (or below -30%).
that carry trading strategies tend to be among the most
profitable FX strategies over time. The most important correlation seems to be between the
Carry Current, the Energy Current and the Current
However, this does not mean that investors need only buy Account Current. Historical observation suggests that the
high-yielding currencies. Table 3 shows the Sharpe ratios Current Account Current and the Carry Current are
of baskets of FX Currents over the whole sample (1999- negatively correlated. We have written extensively about
2009), as well as in individual years. We use two simple the fact that risk-on types of environment favour carry-
weighting methodologies to create our baskets of driven investments, and that at times of risk aversion,
Currents: equal and volatility-adjusted weights (higher current account surplus countries tend to benefit.
vol Currents are assigned lower weights). Three key
things emerge as most interesting on first examination: The cross-linkages between the Energy Current and the
Current Account Current are also interesting, since the
Simple baskets of FX Currents such as these offer large uptrend in commodities over recent years is
better Sharpe ratios on average than any individual responsible for a significant part of the external
Current does. surpluses/deficits across the world. Potentially, the link
between the Energy Current and the Carry Current can be
Equally-weighted baskets offer higher risk-adjusted related to the impact of global growth expectations on
returns compared with volatility-weighted baskets, risky assets and commodity prices alike.
which is an argument for allocating more capital on
higher-risk Currents. Lastly, it is interesting to note that the Valuation and Growth
Currents can be sources of relatively uncorrelated returns.
Table 3: Sharpe Ratios of Simple Static Portfolios of
Sharpe Ratio Equal weights Vol Weights
Constructing an Optimal Portfolio of Currents;
Lessons from Past Experience
1999 3.05 3.03
So far we have discussed evidence that there may be
2000 0.87 0.95
benefits to investing in portfolios of FX Currents and that
2001 1.81 1.70
these benefits may come from the effects of correlations
2002 3.13 3.25
between themes. However, we have looked at portfolios
2003 2.77 3.06
of FX Currents in a static way, disregarding the fact that
2004 1.64 1.97
some of these correlations may be stronger or weaker
2005 3.11 2.87
over time, or that one can change basket weights to adapt
2006 0.85 0.59
to different market conditions.
2007 1.36 1.23
2008 1.70 1.49 In order to better understand how the shifts in the macro
2009 3.12 3.25 trading environment create different sets of opportunities
Whole Sample 1.82 1.77 for different FX Currents, we created ‘optimal’ portfolios
Source: GS Global ECS Research

Chapter 4 23 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

of FX Currents for every year from 1999 to 2008 and for Chart 2: Carry Weights
the first half of 2009. We used daily data for each year to 80.0%
find the combination of FX currents that provided the
highest possible Sharpe ratio. We assume long only 70.0%
positions in FX Currents (so the minimum weight of a
current in a basket is no less than zero) and we assume
that weights always have to sum up to 100%. 50.0%

These assumptions replicate an investor profile of a 40.0%

portfolio manager who has a particular capital to allocate
to FX Currents without extra leverage and without
keeping any of the amount in any form of cash in any 20.0% Overw eight
currency outside those invested in the Currents. This is a
reasonably realistic set of assumptions. Moreover, these 10.0% Underw eight
restrictions help us to avoid corner solutions during the
optimisation process. 1999 2000 20012002 2003 20042005 20062007 2008 2009
Source: GS Global ECS Research
For every year we optimise a portfolio of Currents to
offer the highest (ex-post) Sharpe ratio. Chart 1 shows Current: at one extreme, in 2008 our framework shows
the Sharpe ratios achieved through this optimisation that it would be optimal to be long carry with a weight
process. The chart suggests that very high excess returns less than 14% (underweight relative to an equally-
can be achieved in FX markets by investing through weighted basket). At the other extreme, during 2000,
portfolios of Currents, as long as investors combine them the weight of the carry basket rose above 70%.
in an optimal way. That said, it is important to highlight
that ex-post optimisation is not particularly fair—there As implied by our correlation analysis earlier, owning
will always be an optimal portfolio of FX Currents that the Current Account Current can offer substantial
offers the maximum possible Sharpe ratio. Nonetheless, it diversification benefits. Given the large negative
is still interesting that, in certain years, Sharpe ratios correlation to risky assets, it is unsurprising that the
reached 5.00—a significantly high level of excess returns Current account Current entered the optimal basket in
in a cross-asset context. 2002, 2007 and 2008. What is more interesting is that
during the peak of the ‘carry fever’, in 2006, the CA
In addition, we can extract useful information by looking at basket received its largest weight of more than 40%.
the weights of different optimal portfolios, and understand Lastly, we note that in 2001 and 2007/2008 it was
during what types of trading environments it is optimal to worth holding a combination of the Carry basket and
hold different combinations of FX Currents: the Current Account basket, rather than simply holding
a defensive position by being long the current account.
It is no big surprise that it was worth owning the Carry In other words, it was more profitable to hold a
Current in every year (we have written extensively on diversified position than go outright short risk in the
the systemic reward for risk in carry trading FX markets.
strategies). However, it is also interesting that during
years of cyclical downturns the weight of the Carry There appears to be very little relationship between
basket in the optimal portfolio falls. There is an cyclical forces and EM outperformance. However, our
element of cyclicality in the weights of the Carry exercise here is to look at the BRIC/N-11 Current

Chart 1: Sharpe Ratios of "Optimal Baskets" Chart 3: CA Weights

5.0 45.0%

4.5 40.0%

4.0 35.0%
3.5 30.0%
Overw eight
1.5 15.0%
Underw eight
1.0 10.0%

0.5 5.0%
0.0 0.0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1999 2000 20012002 2003 20042005 20062007 2008 2009
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 4 24 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chart 4: BRIC/N11 Weights Chart 6: Valuation Weights

35.0% 40.0%

30.0% 35.0%

Overw eight 20.0%
Overw eight
Underw eight 15.0%
10.0% Underw eight

5.0% 5.0%

0.0% 0.0%
1999 2000 20012002 2003 20042005 20062007 2008 2009 1999 2000 20012002 2003 20042005 20062007 2008 2009
Source: GS Global ECS Research Source: GS Global ECS Research

within the context of a broader portfolio. Within that 11 Current re-enters the optimal basket in 2008—
portfolio, a number of other Currents reflect cyclical when many EMs had to allow currency appreciation to
risks and broader swings in risk appetite in a more fight inflation pressures (up until the third quarter).
straightforward way (including the Carry Current, as
we showed above). As the correlation analysis above also showed, there is
a large idiosyncratic component to the Growth and
In this context the BRIC/N-11 Current represents the Valuation Current. In the previous cycle, growth
potential for genuine EM outperformance beyond risk became a great theme to own, and in high percentages,
swings. Overall, the BRIC/N-11 Current tends to enter during the early stages of the recovery (2002-2004)
the ‘optimal portfolio’ in years of thematic and in the late part of the cycle (2007-2009). This is an
outperformance of emerging markets. For example, intriguing result in the context of Mark Tan’s work on
the BRIC/N-11 Current only entered the optimal output gaps mentioned earlier. He argues that changes
basket with a significant weight in 1999 (the year of in the output gap tend to matter most for FX
recovery after the EM crises of 1998), in 2005 (which outperformance during the early stages of the
saw significant EM outperformance preceding the recovery.
2006 EM sell-off) and in 2008-2009 (when EMs held
up well despite broader pressures in risky assets). Our Growth Current is based on growth relative to
trend and therefore reflects shifts in the output gap.
Another point to be made here is that the BRIC/N-11 And it is during the recession and the early stages of
Current includes a number of currencies that are the cycle that these shifts tend to be larger and more
managed tightly relative to the USD. It therefore tends visible. In other words, the Growth Current appears to
to stagnate performance-wise during times of be better at capturing the shifts in the output gap when
significant overall Dollar depreciation pressures, such these shifts are most noticeable.
as in 2003 or 2006. Equivalently, changes in FX
policy in emerging markets can result in significant The easiest way to identify patterns in the Valuation
shifts in FX performance. For example, the BRIC/N- Current is to identify the years when it DOES NOT

Chart 5: Growth Weights Chart 7: Energy Weights

80.0% 40.0%

70.0% 35.0%

60.0% 30.0%

50.0% 25.0%

40.0% 20.0%
Overw eight
30.0% 15.0%
Underw eight
20.0% Overw eight 10.0%

Underw eight
10.0% 5.0%

0.0% 0.0%
1999 2000 2001 20022003 2004 20052006 2007 2008 2009 1999 2000 20012002 2003 20042005 20062007 2008 2009
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 4 25 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Table 5: Sharpe Ratios of Currents Subtracting From a practical perspective it is important to verify the
Trading Costs levels of risk/reward in the most realistic set-up possible
Average YLD VAL GRO CA EM ENER to see if our conclusions about the Sharpe ratios of the
Return 6.0% 0.5% 0.7% -2.6% 1.0% 1.1% baskets still hold.
Vol 4.3% 3.3% 2.7% 3.3% 3.5% 2.7%
S.R. 1.4 0.2 0.3 -0.8 0.3 0.4 Finally, there are different costs attached to different FX
Source: GS Global ECS Research Currents. It is therefore important to see whether the
conclusions from the previous section hold or if different
enter the optimal basket. Those years tend to be cost structures influence the optimal basket weights.
towards the late part of the cycle: 1999, 2006, 2007
and 2008. There is no rigorous way of explaining why According to an early estimate of trading costs, fixed
markets tend to focus away from valuation late in the baskets such as the BRIC/N-11 Current or the Energy
cycle but one can intuitively see why this may be the Current cost the least. The Valuation and Growth
case. During the later stage of the cycle, investment Currents are the most costly, while the Current Account
themes with solid fundamental justification tend to and Carry Current costs lie somewhere in the middle.
overshoot as market speculation drives prices beyond
what fundamental benchmarks imply. One example in Including those trading costs reduces Sharpe ratios
the most recent cycle has been the FX valuation significantly. The Carry Current still stands out as the
misalignments created and sustained late in the cycle only Current offering a Sharpe ratio above 1, overall a
in commodity currency space (due to the sharp spike decent reward for risk. Given that Sharpe ratios were
in commodity prices). fairly similar for the Growth, Valuation, Current
Account, Energy and BRIC/N-11 Currents, the different
The patterns in the Energy Current are less obvious. At cost structures make a difference. The lower costs for
the very least, the best years to hold the Current were Energy and BRIC/N-11 Currents keep Sharpe Ratios
not necessarily the best-performing years for oil. This somewhat higher than in the Valuation Current, whose
may well be due to the fact that other Currents may be Sharpe ratio is reduced significantly by trading costs on a
capturing the macro impact of underlying shocks that buy and hold basis. The Current Account Sharpe ratio
also move energy prices. For example, the Carry becomes even more negative.
Current, which is closely correlated with the Energy
Current, may be capturing the pro-cyclical nature of As we showed earlier, although holding these Currents
commodity price fluctuations to a large extent. over time may not have resulted in high Sharpe ratios,
including them in portfolios and managing them according
to certain patterns may offer high reward for risk.
Including Trading Costs in Our Analysis; From
Theoretical to Practical Considerations Including trading costs does not change our results for
So far our analysis has not taken into account trading when returns on holding each individual Current were
costs. From a theoretical perspective, fixed trading costs better. Looking at our optimal basket, the only thing that
over time should not alter our broad conclusions about changes is that, on average, our optimisation gives the
how the optimal combinations of FX Currents within Carry Current a larger weight than without trading costs.
broader portfolios change over time and along the cycle. But that is to be expected given the reduction in Sharpe
However, it is still worth cross-checking that assumption. ratios for other currents, as noted above.

Combining Currents Offers Better Reward for Risk

Chart 8: Sharpe Ratios After Transaction
Although some individual Currents do offer high Sharpe
Costs Remain High
5.00 ratios, combining the Currents in portfolios offers
Without Trading Costs substantially better reward for risk than individual ones,
With Trading costs especially if we adjust for trading costs.

3.50 Another key result from our analysis is that there are
periods in the business cycle when specific Currents are
expected to be relatively more valuable. Our plan is to
2.50 conduct more detailed research in this area, which will be
2.00 critical to using Currents to express shorter-term views
1.50 on macro themes.
Themistoklis Fiotakis
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: GS Global ECS Research

Chapter 4 26 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chapter 5: Updating Our Trade-Weighted Exchange Rates and

Looking at the Real TWIs
Trade-weighted indices are a universally used measure of a currency’s broad strength. We use such indices both
to generate trading recommendations and in our modelling work. In this chapter we present our latest trade
weights and some innovations to the way we calculate the weights, making them a better reflection of a
country’s evolving trade links. We also introduce real trade-weighted indices for all the currencies we cover.
Our TWIs are available on GS Plottool for client use.

Why look at Trade-Weighted Exchange Rates? developed markets. In extreme cases, hyperinflation can
In any given day and over any given period, a currency is significantly distort a nominal TWI. Real trade-weighted
likely to strengthen against some currencies while indices take account of such differences by incorporating
weakening against others. Although bilateral exchange relative price levels into the calculation. As a
rate movements invariably capture the headlines, such consequence, real exchange rates are better-placed to
moves often belie the broader performance of a particular capture longer-term changes in competitiveness than their
currency. A prime example recently has been the CNY. nominal cousins.
Since last summer, it has essentially been fixed against
the Dollar and thus the CNY is broadly assumed to be Method of Calculation
stable. However, if we look at the CNY on a TWI basis, Our TWI weights are based on a large sample of 53
it had appreciated by 15% to early March but has since countries. The weights for each TWI are derived from
depreciated by 10%. this selection. If a country has a weight of 0.5% or more,
it is then included in the index—otherwise it is dropped
Consequently, to gain a sense of a currency’s overall
and the weights are then rebalanced to sum to 1. This
performance, we need to combine each of the bilateral
process is repeated annually; consequently, the country
exchange rates into a single index. The logical weighting
selection can change every year. Reflecting a trend of
system for such an index is to choose weights that reflect
continued globalisation, the number of countries in a
the importance of trading relationships. There is a long
particular TWI tends to increase over time. In the case of
history of using trade-weighted indices (TWIs) in the
Brazil, for example, the number of countries in the TWI
analysis of currency movements and their wider
has expanded from 16 in 1980 to 30 in 2008.
economic implications (for example, the implications of
broad currency movements for net trade). Such indices Each weight is made up of three components: import
are also an appropriate input into Financial Conditions share, export share (which would be found in a ‘simple’
Indices, whereby an appreciation of a currency tends to trade-weighted index) and third-country competition. The
loosen financial conditions. It is also instructive to look at latter requires some explanation. Goods produced in one
the ‘fair value’ of a currency in broader terms. country face competition in two places: in the domestic
market (with imports from other countries) and in export
Nominal TWIs implicitly assume that inflation is the
markets (where the goods face competition from both the
same across countries. In the short run, this is not a
local goods in the target market and third-country exports
particularly bad assumption. However, in the longer run
to that target market). Relative exchange rate changes can
it is less appropriate; for instance, many emerging market
affect such competition. We include third-country effects
economies exhibit higher rates of inflation than more
in the weighting scheme to capture these dynamics. The
calculation also takes into consideration how open an
$/CNY Index
CNY has Appreciated on a TWI Basis economy is by including imports as a share of GDP (for
7.4 38.0 more details on the calculation method, refer to The
Foreign Exchange Market 2004, Chapter 2).
7.3 TWI
Appreciation 36.0
Data Considerations
35.0 The bulk of the underlying data used in the weighting
calculations comes from the IMF, both the Direction of
7.1 34.0 Trade Statistics and International Financial Statistics. We
33.0 aim to update the weights for the previous year in the
7 $/CNY (lhs) following spring, when the latest IMF trade data becomes
CNY TWI (rhs) 32.0 available.
There is much debate in the economic literature over
6.8 30.0 which price measure to use in the calculation of real
Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 exchange rates. Given that a TWI is designed to capture
Source: GS Calculations

Chapter 5 27 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

competitiveness, more appropriate measures of inflation index

US$ TWI: Real vs Nominal
are provided by PPI, WPI or unit labour costs, as these
measures are more reflective of the prices facing
producers. In contrast, CPI tends to include prices for 260
services and other non-tradable products. However, while 240
not the optimal choice, CPI often pans out as the inflation 220
measure of choice because it is timely, widely available
and calculated in a broadly similar fashion across
countries. We have therefore opted for this measure. 180
Lastly, our model of ‘fair value’—GSDEER—also uses 160
CPI inflation for similar reasons. As with the rest of the 140
data, the IMF is the principal source.
The Weights 80
The tables in the appendix to this chapter provide the 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
latest weights for the TWIs of the currencies we cover. Source: GS Calculations
Unsurprisingly, the largest countries in the world (e.g.,
the G3) appear in all the indices. However, given
China and Mexico has intensified. In 1980, 64% of the
increasing globalisation, the growth of emerging market
US TWI weights were accounted for by the so-called
economies and rising commodity prices, many of the
major markets. By 2007, this had slipped to 50.9%. Trade
indices now also ascribe high weights to countries such
dynamics are a slowly evolving process and it would be
as China, Brazil and Russia. India is not as dominant as
unsurprising if this proportion declined further in coming
the other three BRICs countries.
Looking at the history of the TWI weights, we can trace
To supplement the nominal TWI analysis, we have
the rise of globalisation, particularly as the weights of the
introduced a set of real TWIs to remove the distortion of
BRICs economies become larger over time. The weights
inflation from the nominal TWIs.1 The difference
of the N-11 are also likely to become more prominent.
between the nominal and real US TWIs are shown in the
That said, a particular country’s trade links are still
chart above.
strongest with its neighbours. A glance at the set of Asian
weights indicates a different set of important countries in
Fiona Lake, Roman Maranets and Swarnali Ahmed
comparison to the countries that make up the weights in
the Latin American and New European Markets’ TWIs.
Taking a more detailed look at the US TWI, we can see
the rise in importance of emerging markets in USD trade
weights. The accompanying chart shows that while the
importance of Japan, and to a certain extent Canada, has
declined in US trade since the early 1980s, trade with

Evolving weights in the Dollar TWI

Clients can access our TWIs on GS Plottool
15.0% CNY Nominal TWIs are found using the code:
10.0% MXN For instance, the Dollar TWI is GS_USD_TWI

Real TWIs are found using the code:

For instance the real Dollar TWI is GS_USD_RTWI
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
Source: GS Calculations

Chapter 5 28 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market


TWI Weights (%)

ARS TWI - - 0.6 - 30.3 1.1 0.7 3.6 12.6 0.6 - - 0.6 - - - 17.2
AUD TWI 1.1 - - - 0.8 1.3 0.8 - 15.9 - - - - - - - 12.4
BRL TWI - 8.9 0.9 - - 2.0 1.1 2.5 12.9 1.0 - - 1.0 - - - 20.3
CAD TWI - - 0.6 - 0.8 - 0.6 - 7.1 - - - 1.1 - - - 8.1
CHF TWI - - 0.7 - 1.1 1.2 - - 3.5 - 1.0 0.6 - - - - 57.0
CLP TWI - 6.0 0.8 - 8.6 2.4 - - 14.6 2.7 - - - 2.0 - - 15.3
CNY TWI 0.8 0.8 3.1 - 2.6 1.9 0.7 0.9 - - - - - - - - 15.0
COP TWI - 1.3 - - 5.2 2.4 1.4 3.0 7.0 - - - - 2.6 - - 13.0
CZK TWI - - - - - - 1.4 - 3.9 - - 0.9 - - - - 58.4
EUR TWI 0.7 0.6 1.1 - 2.1 1.5 4.7 0.5 9.8 - 3.1 2.3 1.5 - - 0.6 -
GBP TWI 0.5 - 1.1 - 0.9 1.9 1.6 - 6.1 - 1.0 1.3 - - - - 48.5
HKD TWI 0.6 - 1.3 - 0.7 0.9 1.1 - 44.7 - - - - - - - 8.8
HUF TWI - - - - - - 1.3 - 5.6 - 3.5 0.9 - - - - 54.2
IDR TWI 0.7 - 3.7 - 1.1 1.3 - - 12.7 - - - - - - - 9.4
ILS TWI - - 1.0 - 1.5 1.5 4.8 - 6.7 0.6 - - - - - - 30.2
INR TWI 4.0 - 3.8 - 1.8 1.4 0.9 0.7 16.2 - - - - - - - 18.3
JPY TWI 4.1 - 5.1 - 1.3 2.0 0.8 0.8 19.8 - - - - - - - 10.8
KRW TWI 2.6 - 3.3 - 1.4 1.5 - 1.0 24.4 - - - - - - - 10.0
MXN TWI - 0.6 - - 2.0 4.5 - 0.8 5.5 0.8 - - - - - - 9.3
MYR TWI 1.1 - 3.5 - 0.9 1.1 0.7 - 15.0 - - - - - - - 10.1
NOK TWI - - - - 1.0 2.8 1.1 - 4.8 - 0.9 5.6 - - - - 40.5
NZD TWI 1.1 - 20.7 - - 1.6 0.6 - 11.5 - - 0.6 - - - - 11.5
PEN TWI - 3.0 - - 6.6 4.5 1.5 5.2 13.1 3.5 - - - 3.5 - - 13.2
PHP TWI 1.5 - 2.0 - 1.0 1.3 - - 19.6 - - - - - - - 8.8
PLN TWI - - - - - - 1.1 - 3.6 - 4.0 1.8 - - - - 57.0
RUB TWI - - - - 1.5 0.7 1.8 - 10.9 - 1.5 0.7 - - - - 38.3
SEK TWI - - 0.9 - 0.8 0.8 1.1 - 3.9 - 1.2 8.5 - - 0.6 - 45.0
SGD TWI 1.8 - 3.4 - 0.7 0.9 0.7 - 13.5 - - - - - - - 11.6
THB TWI 4.1 - 4.2 - 1.2 1.0 1.7 - 13.1 - - - - - - - 9.6
TRY TWI 1.5 - 0.6 1.0 0.8 0.9 2.8 - 6.3 - 0.8 0.7 1.7 - - 0.8 35.2
USD TWI - - 1.4 - 2.5 18.3 1.2 0.7 13.5 0.9 - - 0.6 - - - 16.6
VEB TWI - 2.3 - - 7.1 2.4 0.8 1.8 7.7 10.3 - - - 1.0 - - 11.5
ZAR TWI 1.0 1.6 2.4 - 2.1 1.3 1.4 - 11.7 - - - - - - - 26.5
Continued on the next page…

Chapter 5 29 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

TWI Weights (%)

ARS TWI 1.7 0.8 - - 0.7 - 1.2 2.2 1.3 - - - 2.9 0.6 - - -
AUD TWI 4.8 1.5 - - 2.5 - 3.4 16.6 4.6 - - - 0.7 3.1 - - 3.6
BRL TWI 2.4 0.8 - - 0.8 - 1.6 5.0 2.6 - - - 2.4 0.8 2.7 0.5 -
CAD TWI 3.3 - - - - - 0.7 3.7 1.3 - - - 3.4 - - 1.1 -
CHF TWI 5.2 1.0 - 0.6 - 1.2 0.9 3.1 0.7 - - - 0.5 - - 0.6 -
CLP TWI 1.4 - - - - - 2.0 8.3 5.4 - - - 3.5 - - - -
CNY TWI 2.5 4.1 - - 1.7 - 2.8 14.1 9.0 0.7 - - 1.0 2.5 - - -
COP TWI 2.1 0.7 - - - 0.7 1.0 2.8 1.8 - - - 5.9 - - - -
CZK TWI 4.9 0.9 - 2.6 - - - 1.8 0.6 - - - - - - - -
EUR TWI 13.7 0.9 - 2.0 - 0.8 1.8 4.1 1.8 0.7 - - 1.2 0.8 0.8 2.8 -
GBP TWI - 0.8 - 0.7 - - 1.6 2.6 1.1 - - - 0.6 0.5 - 4.2 -
HKD TWI 2.2 - - - 1.0 - 2.2 8.4 3.3 - - - - 1.9 - - -
HUF TWI 4.2 - 0.8 - - - 0.5 2.1 1.4 - - - - - - - -
IDR TWI 1.4 2.7 - - - - 4.0 17.3 5.7 - - - - 5.6 - - 0.6
ILS TWI 4.7 2.2 - - - - 3.7 3.5 1.8 - - - 0.6 - - - -
INR TWI 4.5 2.6 - - 3.0 1.0 - 5.2 3.6 - - - 0.9 2.5 0.6 - -
JPY TWI 2.0 1.1 - - 3.5 - 1.4 - 5.7 - - - 1.1 2.4 - - -
KRW TWI 1.8 1.9 - - 2.4 - 2.0 14.0 - - - - 1.3 1.9 - - -
MXN TWI 1.1 0.7 - - - - 0.7 3.2 3.2 - - - - 1.2 - - -
MYR TWI 1.9 3.3 - - 4.6 - 2.7 11.6 4.3 - - - 0.6 - - - 0.6
NOK TWI 16.3 - - - - - 0.5 2.1 1.2 - - - - - - - -
NZD TWI 3.5 1.1 - - 2.8 - 1.4 10.3 3.3 - - - 0.8 3.2 - - -
PEN TWI 1.2 0.7 - - - - 0.9 5.9 2.7 - - - 2.8 - 0.7 - -
PHP TWI 1.5 3.5 - - 2.6 - 1.1 15.1 4.4 - - - - 3.3 - - 0.6
PLN TWI 5.4 - - 1.9 - - - 1.0 1.4 - - - - - - 1.6 -
RUB TWI 4.0 0.6 - 1.4 - - 1.2 5.8 3.5 2.9 - 0.7 - 0.6 - - -
SEK TWI 8.1 - - 0.7 - - 0.9 2.0 0.8 - - - - - - 9.5 -
SGD TWI 2.4 1.7 - - 5.9 - 3.8 9.8 5.5 - - - 0.6 8.8 - - -
THB TWI 2.1 1.6 - - 3.8 - 2.2 19.1 3.9 - - - - 4.4 - - -
TRY TWI 5.5 - - 0.7 0.7 1.2 1.2 2.0 1.7 1.1 - - - 0.6 - - -
USD TWI 4.2 0.9 - - 0.9 1.1 1.7 7.5 2.7 - - - 11.3 1.2 1.3 - -
VEB TWI 1.6 - - - - - - 1.8 - - - - 4.6 - - - 0.6
ZAR TWI 8.3 1.0 - - 0.8 0.7 2.6 9.3 2.4 - - - - 1.1 1.8 - -
Continued on the next page…

Chapter 5 30 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

TWI Weights (%)

ARS TWI - 0.9 - - - - 1.9 - - - - 0.7 0.7 0.6 - 14.5 1.1 - 0.9
AUD TWI - - 0.6 - - - 0.6 0.8 0.9 4.5 - 3.3 - 2.2 - 11.5 - 1.6 0.9
BRL TWI - 0.8 - - - - 2.5 1.6 0.8 0.9 - 0.8 0.6 1.2 - 18.2 1.6 - 0.7
CAD TWI - - - - - - 0.6 - - - - - - - - 67.5 - - -
CHF TWI - - - 1.0 - - 3.5 0.6 1.0 - - 1.0 2.2 - - 11.8 - - -
CLP TWI - 2.8 - - - - 0.5 - 0.8 - - 0.6 1.2 1.2 - 18.8 1.2 - -
CNY TWI 0.6 - 1.7 - - - 2.9 2.2 - 2.2 - 2.0 0.7 4.6 - 17.6 - 0.6 0.8
COP TWI - 2.1 - - - - - - - - - - - 0.7 - 35.7 10.5 - -
CZK TWI - - - 6.6 - 1.0 5.6 - 1.6 - 5.2 - 0.8 - 0.9 2.9 - - -
EUR TWI - - - 4.5 - 1.4 7.3 1.4 3.7 0.8 1.4 0.8 2.8 0.9 0.8 13.6 - - 1.0
GBP TWI - - - 1.5 - - 2.3 0.6 2.2 0.8 - 0.6 1.4 0.6 - 13.6 - - 1.3
HKD TWI - - 1.3 - - - - - - 4.0 - 1.7 - 4.9 - 11.0 - - -
HUF TWI - - - 4.3 - 3.3 7.7 - 1.2 - 3.0 - 1.2 - 1.5 3.3 - - -
IDR TWI - - 1.1 - - - 0.9 2.5 - 10.1 - 3.8 0.9 3.1 - 10.5 - 0.8 -
ILS TWI - - - 0.6 - - 2.0 - 1.0 0.8 - 0.9 3.2 0.9 - 26.9 - - 0.9
INR TWI - - - - 0.9 - 2.2 1.8 0.8 3.7 - 1.6 0.9 1.4 - 14.7 - - 1.0
JPY TWI 0.7 - 1.3 - 2.2 - 2.3 4.6 - 1.5 - 2.9 - 3.2 - 17.5 - 0.9 1.0
KRW TWI 0.8 - 1.0 - 1.6 - 2.7 4.3 - 2.5 - 1.3 0.6 2.4 - 13.0 - - 0.6
MXN TWI - - - - - - - - - 0.7 - - - 0.6 - 64.3 0.8 - -
MYR TWI - - 1.8 - - - 0.7 1.1 - 13.0 - 4.6 - 2.8 - 12.9 - 1.2 -
NOK TWI - - - 2.3 - - 2.1 - 11.1 - - - 0.7 - - 7.0 - - -
NZD TWI - - 0.9 - 1.8 - 0.5 1.4 0.6 3.3 - 2.3 - 1.9 - 12.1 0.7 - 0.5
PEN TWI - - - - - - 0.9 - 0.7 - - 0.7 - 1.1 - 25.1 2.5 - -
PHP TWI - - - - - - - 3.4 - 6.4 - 3.7 - 4.5 - 14.8 - 1.1 -
PLN TWI - - - - - 1.0 9.1 - 3.0 - 1.8 - 1.3 - 1.9 2.9 - - -
RUB TWI - - - 3.7 - 0.8 - - 1.6 - 1.1 - 4.4 0.5 5.5 6.2 - - -
SEK TWI - - - 3.2 - - 4.2 - - - - - 1.1 - - 6.3 - - 0.6
SGD TWI - - 1.9 - 1.6 - 0.8 3.1 - - - 3.6 - 3.2 - 13.8 - 0.9 -
THB TWI 1.1 - 1.6 - 1.1 - 1.4 3.1 - 3.4 - - - 2.6 - 11.9 - 0.8 0.7
TRY TWI - - - 1.5 - 2.4 13.2 2.0 1.1 - - 0.6 - 0.6 2.6 7.2 - - 0.9
USD TWI - - 0.6 - - - 1.4 2.1 0.6 0.9 - 1.0 0.6 1.6 - - 2.0 - 0.6
VEB TWI - 1.6 - - - - 1.4 - 0.6 - - - - - - 42.9 - - -
ZAR TWI - - - 0.6 - - 0.6 3.9 1.4 1.0 - 1.5 1.7 1.2 - 12.3 - - -

Chapter 5 31 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chapter 6: Empirical Links Between the Major Currencies and

their BBoP Flows
Following the template of the US BBoP analysis published in the previous issue of The Foreign Exchange
Market, we empirically select the balance of payments components that best explain variations in the real trade-
weighted exchange rate of other major currencies. We again find strong evidence that the BBoP matters,
although the exact composition is slightly different for each country. In almost all cases, trade flows and the
components of the current account are key drivers of exchange rates. The relevance of FDI and portfolio flows
is less systematic. While these capital flows matter a lot for the EUR, CAD and AUD, the results are more mixed
for countries with large financial centres (UK, CHF) or stronger FX policy influence (JPY, NOK).

The BBoP framework has long been part of our currency for New Zealand due to limited historical data; however,
analysis. Introduced in 1999 as an extension of the other research we have conducted indicates that the
academic Basic Balance (current account + FDI), we BBoP model is useful in explaining developments in the
included portfolio flows to gain a better sense of overall NZD (see The Foreign Exchange Market 2007, Chapter
‘commercial’ demand and supply factors in currency 5: “Empirical and Theoretical Links between the US
markets. Our basic thesis runs that, if a country with a BBoP and the Dollar”).
current account deficit is able to attract enough FDI and
portfolio inflows to finance that deficit, then demand and As in the previous analysis on US data, we again tried to
supply factors are currency neutral. By focusing on the find the best cointegrating vector that links the level of
current account deficit alone, one could wrongly the exchange rate to a combination of cumulative cross-
conclude that the currency is under depreciation pressure. border capital flows. We ran the same model selection
Thus, we consider a BBoP surplus to be a positive factor routine, which tries to optimise the fit of a linear
for a currency, and a deficit to be a negative. regression, while using as few additional variables as
possible. We use the Akaike Information Criterion (AIC)
In the 2007 edition of this publication (Chapter 5: to decide if any n+1 variable combination helps improve
“Empirical and Theoretical Links between the US BBoP on the best n variable model. More specifically, our
and the Dollar”), we examined the empirical links program first regresses the level of the exchange rate on
between the real US$ TWI and the BBoP flows in some each individual right-hand-side variable and a constant,
detail, and explained in more depth the theoretical links and selects the one with the highest AIC. In the second
between balance of payments flows and exchange rates. step, it iterates through all possible two variable
Building on standard results of academic FX combinations and checks whether the best solution
microstructure literature, namely that a strong improves on the optimal combination from the previous
relationship exists between order flows and changes in one-variable step. If positive, we iterate through all three
the exchange rates, we showed that such a relationship variable combinations, and add increasing numbers of
also holds on a macro level, when using balance of variables until the inclusion of an additional variable no
payments data. Specifically, we showed that there is a longer improves the result from the previous step.
particularly strong long-run relationship (cointegration)
between cumulative BBoP flows and the level of Once the optimal model is found, we test the
exchange rates. cointegration properties more formally and critically
examine the coefficient estimates. As a general rule, all
Using an automated variable selection procedure, we coefficients should have the same positive sign, as
achieved particularly strong results with a subset of the balance of payments conventions prescribe that inflows
components in the BBoP, namely goods imports and (credits) are positive and hence expected to be associated
exports, foreign purchases of US equity and foreign with currency appreciation. However, depending on how
purchases of US debt. We extend this analysis here to the FX-relevant the individual balance of payments
rest of the major currencies and discuss the results. components are, the size of the coefficients can be quite

Variables Included in the Selection Process

Regression and Variable Selection Procedures
Goods: Exports Goods: Imports
Mirroring the analysis published last year on the USD,
we have attempted to find the best combination of Services: Exports Services: Imports
components of the BBoP to explain the real trade- Income: Receipts Income: Payments
weighted exchange rates of the other major currencies. Current Transfers: Receipts Current Transfers: Payments
The variables included in the selection process are listed
Domestic Direct Investment Direct Investment Abroad
in the table alongside. Certain countries do not publish
the full breakdown of the BBoP components; thus we Foreign purchases of US Equity US Purchases of Foreign Equity
have used the balances when the separate credit and debit Foreign Purchases of US Debt US Purchases of Foreign Equity
data was not available. We did not undertake the analysis
Source: GS Global ECS Research

Chapter 6 32 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Index Index
Euroland Real TWI Model JPY Real TWI Model
160 240
145 200

130 160

125 Actual
Fitted Actual
120 Fitted
110 100
99 00 01 02 03 04 05 06 07 08 09 10 91 93 95 97 99 01 03 05 07 09
Source: GS Global ECS Research, Haver Analytics Source: GS Global ECS Research

different. In particular, the coefficients for largely FX- The sign on services exports and transfers is likely to
hedged inflows (more common in fixed-income-related pick up reverse causalities. In particular, European
flows) tend to be smaller. tourism is likely to be benefit from a weak currency.
Therefore, a stronger EUR would be associated with
fewer services exports. This also suggests that services
Results Broadly In Line With US BBoP Analysis
exports are quite sensitive to FX.
In general, the results are intuitive and in line with our
analysis of the US BBoP, although each individual On the transfer component, Euroland residents may shift
country represents specific issues. We examine each relatively more deposits into foreign currency
country’s results in turn. denominated accounts abroad when the Euro is relatively
strong, and vice versa. In terms of volumes, both services
Euroland. The variable selection procedure selected a
exports and transfers matter relatively less than the other
broad range of Euroland BBoP constituents (see the
flows selected.
accompanying table below for details). It is particularly
interesting to see the selection of the FDI and equity Japan. As with the other currencies we cover, we have
components. This reflects what we have long held to be always paid close attention to the Japanese BBoP.
important drivers of the EUR. In its early days, the single However, the flows have had an inverse relationship with
currency was under a lot of pressure due to FDI and the Yen, i.e., when the BBoP was in strong positive
equity outflows, particularly to the US, associated with territory in recent years, the Yen was weak. Through this
the ‘dot com’ boom and the serial underperformance of period the carry trade outweighed the influence of
the Euroland economy. In subsequent years, Euroland’s portfolio flows when it came to driving the Yen. Thus,
growth outperformance relative to expectations has we looked forward to the results of the model. We are
helped attract capital and provide a backdrop for Euro intrigued to see that goods and services trade have been
appreciation. More recently, repatriation of foreign selected as important with the correct sign, as have
holdings of overseas assets has been important for the income debits. The selection of trade reflects the
Euro. importance of the externally facing parts of the Japanese
economy, and the highly significant coefficients
The most striking result is the negative sign on services
underline the importance of goods trade for Japan.
credits and transfer debits, which points to an inverse
relationship between these two variables and the Euro.
JPY Real TWI: Model Results*
Variable Coefficient Std. Error t-Statistic Prob.
Euroland Real TWI: Model Results*
Constant 163.1265 4.2255 38.6055 0.0000
Coefficient Std. Error t-Statistic Prob.
FDI Domestic -0.0006 0.0001 -4.3317 0.0000
Constant 135.484 1.633 82.941 0.000 Equity Assets -0.0004 0.0001 -4.2108 0.0000
Goods Exports 0.085 0.016 5.417 0.000 Equity Liabilities -0.0001 0.0000 -4.5004 0.0000
Services Credit -0.308 0.040 -7.672 0.000 Goods Exports 0.0005 0.0000 13.8976 0.0000
Transfers Debit -0.197 0.054 -3.658 0.000 Goods Imports 0.0007 0.0001 12.3370 0.0000
FDI Abroad 0.053 0.006 8.357 0.000 Services Credits 0.0007 0.0002 3.8807 0.0001
FDI Domestic 0.039 0.008 5.135 0.000 Services Debits 0.0002 0.0001 2.6807 0.0079
Equity Assets 0.079 0.006 12.484 0.000 Income Debits 0.0003 0.0000 6.4341 0.0000
Equity Liabilities 0.031 0.004 7.767 0.000 Transfer Credits -0.0044 0.0007 -6.4663 0.0000
R-squared 0.897 Akaike info criterion 5.203 R-squared 0.8360 Akaike info criterion 7.415
Adjusted R-squared 0.891 Schwarz criterion 5.384 Adjusted R-squared 0.8289 Schwarz criterion 7.569
*Monthly data since 1999. Source: Haver Analytics, GS Global ECS Research *Monthly data since Jan 1991.Source: Haver Analytics, GS Global ECS Research

Chapter 6 33 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Index Index
CAD Real TWI Model AUD Real TWI Model
125 110
120 105
115 100 Fitted
105 Actual
100 Fitted
85 75

80 70

75 65
90 92 94 96 98 00 02 04 06 08 10 88 90 92 94 96 98 00 02 04 06 08
Source: GS Global ECS Research Source: GS Global ECS Research

Given the dominance of Japanese buying of foreign bonds One puzzle is the wrong sign on transfer credits, which
in Japanese portfolio flows, it is interesting that this suggests that transfers into Canada have an inverse
component of the capital account has not been selected. relationship with the Canadian Dollar direction. Again, as
This suggests that these flows are fully hedged. Instead, already seen for the Euro-zone and Japan, this may
FDI abroad and both sides of the equity ledger are selected simply reflect another reverse causality, i.e., that foreign
as important variables. However, they have the wrong investors shift deposits into CAD-denominated accounts
sign, which may reflect reverse causalities. With the when the Canadian Dollar appears relatively cheap and
Japanese equity market dominated by exporting vice versa. Given their size relative to other components,
companies, foreign purchases of Japanese stocks may pick transfer payments are unlikely to materially affect the
up when a falling Yen improves exporters’ profitability. BBoP relationship in any case.
For similar reasons, Japanese investors may pull out of
overseas equities and re-allocate to domestic stocks. Australia. The model for the real AUD TWI throws up
some interesting results. Although Australia is a large
Canada. We modelled the Real CAD TWI over two commodity exporter, exports are not selected. That said,
periods, from 1980, when the balance of payments data the much smaller flows associated with services exports
begins, and from 1990. The results presented here are appear important. FDI flows on both sides of the ledger
those from 1990, which coincides with the period that are selected as important. Equity and bond liabilities are
was influenced to a far lesser extent by capital controls. also selected as important, reflecting strong foreign
interest in Australian assets. Foreign buying of Australian
Similar to the Real EUR TWI results, those for the Real debt has been strong in recent years, reflecting the
CAD TWI indicate that a broad range of BBoP influence of the carry trade, but also the need to fund the
components are key drivers of the currency. The results are chronic current account deficit. The anomaly is the
intuitive and highly significant. It is no surprise that goods negative sign on the income credit variable, possibly
exports and imports are selected, given that Canada is a hinting at some FX sensitive behaviour by Australian
small open economy. FDI is also a selected variable; overseas investors. Specifically, the negative sign could
indeed, Canada has benefited from strong net FDI inflows suggest that overseas profits are more likely to be
into the commodity sector. The selection of equity assets repatriated when the AUD is particularly weak.
may reflect the influence of the large Canadian pension
funds and their activities in foreign assets.

Canada Real TWI: Model Results* Australian Dollar Real TWI: Model Results*
Variable Coefficient Std. Error t-Statistic Prob. Variable Coefficient Std. Error t-Statistic Prob.
Contant 174.9978 6.5365 26.7725 0.0000 Constant 94.0710 1.1759 79.9989 0.0000
Goods exports 0.0003 0.0000 7.0244 0.0000 Services Exports 0.0013 0.0001 11.6533 0.0000
Goods imports 0.0006 0.0000 19.5680 0.0000 Income Credits -0.0015 0.0001 -10.7137 0.0000
Services exports 0.0024 0.0002 10.2857 0.0000 Transfer Debits 0.0079 0.0007 11.5443 0.0000
Income credits 0.0006 0.0001 8.5672 0.0000 FDI Abroad 0.0004 0.0001 4.8066 0.0000
Transfer Credits -0.0082 0.0009 -8.9786 0.0000 FDI Domestic 0.0005 0.0001 5.1657 0.0000
FDI Abroad 0.0002 0.0000 4.9597 0.0000 Equity Liability 0.0006 0.0001 6.5392 0.0000
FDI Domestic 0.0001 0.0000 3.8752 0.0002 Bonds Liability 0.0002 0.0000 9.2543 0.0000
Equity Assets 0.0003 0.0001 4.4886 0.0000 R-squared 0.873 Akaike info criterion 5.363
R-squared 0.954 Akaike info criterion 4.820 Adjusted R-squared 0.861 Schwarz criterion 5.596
Adjusted R-squared 0.948 Schwarz criterion 5.096 *Quarterly data from 2Q1988. Source: Haver Analytics, GS Global ECS Research
*Quarterly data from 1990. Source: Haver Analytics, GS Global ECS Research

Chapter 6 34 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Index Index
GBP Real TWI Model SEK Real TWI Model
115 80


105 Actual 75


80 Actual

70 55
90 92 94 96 98 00 02 04 06 08 10 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: GS Global ECS Research Source: GS Global ECS Research

UK. The model selection for the real Sterling TWI Sweden. Given that Sweden is a small open economy, it
picks variables from the current account and capital is unsurprising to see exports and imports selected as a
account. The components of the current account have key driver of the SEK. The model also finds that
the correct sign; however, the components of the Swedish direct investment abroad is a key driver of the
financial account tend to have a negative sign. SEK but FDI into Sweden is not. It is interesting to see
Interpreting the UK capital account from an FX Swedish buying of foreign debt selected but with the
perspective has always been fraught with complications, wrong sign. Swedes are large buyers of foreign debt due
largely because the transactions are not recorded with to their pension fund program. The negative sign could
the location of the person doing the transaction in mind. reflect the hedging of that debt. Overall, however, the
For instance, a German investor buying a US bond fit is not as good as for a number of other countries,
through London is a transaction that does not involve possibly affected by the heavy weight of the EUR in the
the Pound—but it is potentially recorded as a UK Swedish TWI, which may not reflect the regional
purchase of a US bond. Thus we are not surprised that distribution of cross border flows.
some of the variables have a negative sign. It is also
interesting that bond liabilities have the correct sign and
may reflect the importance of foreign investors in the
Gilt market.

GBP Real TWI: Model Results SEK Real TWI: Model Results*
Variable Coefficient Std. Error t-Statistic Prob. Variable Coefficient Std. Error t-Statistic Prob.

Constant 86.3289 5.5368 15.5917 0.0000 Constant 87.8824 5.6289 15.6128 0.0000
Goods exports 0.0003 0.0000 8.6016 0.0000 Goods exports 0.0400 0.0090 4.4426 0.0001
Income debits 0.0001 0.0000 6.5381 0.0000 Goods imports 0.0457 0.0112 4.0812 0.0002
Transfer credits 0.0024 0.0004 5.5686 0.0000 FDI Abroad 0.0266 0.0044 5.9966 0.0000
Transfer debits 0.0039 0.0006 6.9846 0.0000 Debt assets -0.0251 0.0087 -2.9010 0.0060
Equity liability -0.0002 0.0000 -4.6007 0.0000 R-squared 0.7369 S.D. dependent var 3.8167
Bonds liability 0.0001 0.0000 2.5641 0.0126 Adjusted R-squared 0.7106 Akaike info criterion 4.3812
FDI abroad -0.0002 0.0000 -5.5191 0.0000 *Quarterly data starting 1998. Source: Haver Analytics, GS Global ECS Research

Bonds assets -0.0001 0.0000 -8.3191 0.0000

R-squared 0.8852 S.D. dependent var 9.9253
Adjusted R-squared 0.8717 Akaike info criterion 5.4841
Source: Haver Analytics, GS Global ECS Research

Chapter 6 35 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

index Index
NOK Real TWI Model CHF Real TWI Model
115 100
98 Actual
110 Fitted
Fitted 94
100 90
85 80
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Norway. Norway’s balance of payments is complicated neighbours, which dominate the trade-weighted CHF.
by the management of the country’s oil wealth. In This kind of reverse causality suggests that the Swiss
principle, the oil revenues in the current account should Franc is driven by other factors, not necessarily linked to
offset much of the portfolio flows abroad. However, the BBoP components, but may be more dependent on short
non-oil mainland economy also has trade and investment rate differentials and carry flows.
relationships with other countries, and these should
become visible via our selection procedure.
Increased Confidence in BBoP Model
Our empirical results underline the relevance of the Extending the BBoP mining exercise to the other major
aforementioned complications through a comparatively currencies has increased our confidence in the concept of
poor fit, in particular since the petroleum fund started to the BBoP to determine currency movements. In most
play a more important role in the early 2000s. However, cases the model provides sensible results, reaffirming our
it is interesting that non-oil exports, goods imports and views that BBoP flows are important drivers of
FDI abroad are still all selected. They are also the least currencies. Where the model provided weak results, this
oil-affected components of the Norwegian BBoP, was for currencies where the balance of payments flows
although the relatively low level of significance are complicated by either the dominance of a financial
compared with other countries is a further reminder that centre (GBP and CHF), oil flows (NOK) and the carry
the NOK may be subject to substantial policy trade for the Yen. In many cases we suspect there may be
intervention. reverse causalities, which may need further investigation,
in particular with regard to non-BBoP factors in the
Switzerland. Switzerland’s balance of payments suffers balance of payments that may be a driver of FX. Carry-
from the same problems as that of the UK, namely, that related shifts in the Other Investment Account may
the capital account flows are complicated by the deserve particular examination in those cases where the
dominance of the financial sector in Switzerland. That standard BBoP analysis looks less appropriate.
said, our model for the Real Swiss TWI selects equity
liabilities with the correct sign. The negative sign on both Fiona Lake and Thomas Stolper
sides of the income balance potentially indicates similar
reverse causalities, as seen for a number of other
countries above. Even goods imports may be affected by
the same problem, with imports rising when the Swiss
Franc is particularly strong relative to its Euro-zone

CHF Real TWI: Model Results*

NOK Real TWI: Model Results* Variable Coefficient Std. Error t-Statistic Prob.
Variable Coefficient Std. Error t-Statistic Prob.
Constant 91.7299 0.7563 121.2873 0.0000
Constant 95.384 1.010 94.433 0.000 Goods Imports -0.0001 0.0000 -4.4010 0.0001
Non-oil exports 0.000 0.000 3.746 0.000 Income receipts -0.0002 0.0000 -4.9631 0.0000
Goods imports 0.000 0.000 3.620 0.001 Income expenditure -0.0001 0.0000 -3.6960 0.0007
FDI Abroad 0.000 0.000 2.474 0.016 equity liabilities 0.0002 0.0000 4.1728 0.0002
R-squared 0.2817 S.D. dependent var 3.6858 R-squared 0.8301 Akaike info criterion 3.8227
Adjusted R-squared 0.2439 Akaike info criterion 5.2306 Adjusted R-squared 0.8112 Schwarz criterion 4.0317
*Quarterly data starting 1994. Source: Haver Analytics, GS Global ECS Research *Quarterly data starting 1999. Source: Haver Analytics, GS Global ECS Research

Chapter 6 36 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chapter 7: Over-fitting in Cross-Asset Proxy Baskets

In recent years, FX investors have increasingly looked at cross-asset correlations and have also attempted to
express fundamental views on other asset classes through customised FX baskets. Using copper prices as a
concrete example, we discuss the implications of this approach by pushing it to the extreme in terms of over-
fitting. We observe the expected parameter instability and a surprisingly weak fit in general. But we also find
clusters of stable and relatively high correlation. These clusters tend to appear when the target asset is ‘on the
move’. In practical terms, highly optimised proxy baskets are therefore likely to be more useful than basic
statistical analysis would suggest.

The Pros and Cons of Cross-Asset Proxy Baskets will discuss the periods during which we think a proxy
Expressing views on other asset classes through FX FX basket is likely to have more success.
markets is an attractive proposition for many investors,
for a variety of reasons. Despite the expected out-of-sample instability introduced
through the short optimisation window, some currencies
Some investors may not be able to express a show very stable coefficients and appear much more
fundamental view directly in the desired asset class, frequently in optimised baskets than others. These also
such as commodities or equities, but do have access to tend to be the currencies with the strongest fundamental
the FX market, and therefore will be able to construct links to the target asset class.
a proxy basket of currencies to replicate the off-limit
asset class. Overall, it appears the risks of over-fitting can be reduced
substantially by:
Liquidity and depth are a key feature of FX markets;
hence, even if institutional access restrictions are not reducing the range of possible basket constituents to
in place, it may still be attractive to consider a those with strong fundamental links, and
substitute FX portfolio. Slippage may be much smaller
for larger positions relative to the underlying target focusing only on those periods when the target asset
market. Moreover, 24-hour liquidity in most class is ‘in play’.
currencies may present considerable risk management
advantages relative to other asset classes, which may Basket Estimation Strategies
be restricted to a few trading hours per day. In very general terms, there are a number of key choices
to make when constructing FX portfolios as proxies for
FX markets may theoretically provide a way to obtain other assets.
specific exposure to the long-term outlook of other
asset classes, to the extent that exchange rates pick up Sample size. The choice of the sample size depends on
related changes in the economy. This may be the trade-off between fit versus robustness. Over very
particularly attractive for certain commodities, where short samples, it is possible to create almost perfectly
storage is costly or virtually impossible. correlated cross-asset relationships, but these may well be
spurious and immediately break down out of sample.
However, these advantages come at a cost. For example, Over longer horizons the robustness increases but the fit
considerable leverage may be needed in the FX portfolio typically deteriorates. In this piece, our aim is to find
to obtain the degree of return volatility that the baskets with rather high correlations and we are
underlying target asset displays. specifically interested in the implications for robustness.
The idea is also to look at sample sizes that correspond to
And, most importantly, the correlations between the average holding period of a typical discretionary
exchange rates and the target asset class may change over macro trade, which is not more than a few weeks or
time. After all, currencies are driven by a very wide range months. We chose a three-month (60 business days)
of fundamental factors and not just those relevant for the rolling window.
target asset. With too short a sample period, there is a
substantial risk of over-fitting currency baskets, with Levels versus changes. This is probably the most
negative implications for out-of-sample stability. important choice to make. Standard regression models
are based on the assumption that the dependent and
Our main focus here is on the stability of baskets explanatory variables are stationary. However, when
optimised over very short windows. To illustrate the estimating daily changes, the risk is that a regression
implications of such a deliberate over-fitting exercise, we model gives too much weight to those observations
use copper prices as a practical example. where a large temporary divergence occurs. In those
cases, estimations in levels may be more appropriate but
We show that, even with the best optimisation procedures
only under specific conditions. All variables have to be
and over a short sample, it is often not possible to build
integrated and the residuals stationary to satisfy standard
well-fitting proxy FX baskets for other asset classes. We

Chapter 7 37 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

assumptions in a so-called co-integration relationship. It Number of

Baskets Fit of Proxy Baskets Often Disappoints
is not uncommon for financial data to display co-
integration relationships even over relatively short 800

samples. However, over the short three-month sample 700 Distribution of R-squared
chosen above, it is probably safer to stick to changes.
Variable selection. There are many variable selection 500
strategies and by adding more currencies to the FX basket
it is always possible to improve the fit relative to the 400
target asset. That said, insignificant variables will 300
deteriorate the out-of-sample performance. A number of
test statistics help with the variable selection. We 200
combined the use of the AIC test statistic with an 100
iterative procedure that literally runs through all possible R-squared
currency baskets until the one with the best AIC score 0
< 0.1 < 0.2 < 0.3 < 0.4 < 0.5 < 0.6 < 0.7 < 0.8 < 0.9 <=
has been found. Specifically, we first limit our currency
universe to the 17 most liquid Dollar crosses (AUD, Source: GS Global ECS Research
NOK, NZD, PLN, RUB, SEK, TRY, ZAR). We then target asset through a proxy FX basket. The average R-
regress our target asset on each of the 17 variables squared over our 2,710 optimal FX baskets is only 23%.
individually, on all two-variable combinations, three- A more detailed look at the distribution of R-squared
variable combination, and so on. Once we find an n- shows that a relatively large part of the distribution has
variable combination with an AIC criterion that cannot be an extremely weak fit of less than 10%. This is rather
improved by any (n+1)-variable combinations, we retain surprising given our deliberate over-fitting strategy.
the n-variable results as the best possible basket over the Cross-asset proxy baskets should therefore be used very
sample window. After shifting the sample window by selectively and with great precaution, as there is always a
one observation, we repeat the whole variable selection risk that a tight relationship breaks down out of sample
procedure. Iterating through 10 years of data frequently and to a degree that many may not expect.
implies estimating several million regressions in this
‘brute force’ approach. However, we can be confident However, there are also periods when the R-squared is
that if there were any well-fitting FX basket, our routine very high, in particular when taking into account that the
would find it. model is estimated in changes. We find peak R-squared
readings of almost 80%. Even more interesting, the FX
Other factors influencing basket selection. We have baskets show a particularly high R-squared when
deliberately discounted a number of factors for this volatility in copper, also measured over a three-month
analysis, such as transaction costs or bid-offer spreads, horizon, is particularly high (see chart).
which may be quite different for the currencies
mentioned above. Moreover, we also did not rebalance The second factor that seems to affect the fit of the
our portfolio. Of course, the estimated regression currency baskets is the level of the target asset price. The
coefficients are proportional to the constant weights over next chart shows that when copper prices are high the R-
the sample period of the respective currency. However, if squared values of the FX models appear to be higher,
one currency on the long side continues to appreciate whereas at lower price levels the R-squared also appears
steadily over the sample period, its weight will likely to be low. This factor seems to have been particularly
increase. Theoretically, one would have to rebalance the
Vol (%)
basket but we assume our sample is short enough not to % Proxy Baskets Fit Improves on High Target
worry about this issue. Asset Volatility
0.9 80
Rolling R-squared of optimised
0.8 baskets (LHS) 70
Results Show Clusters of Stability
0.7 Copper: 3mth realised volatility
Following the discussion above, our aim was to find 60
optimised FX baskets to proxy copper as the target asset. 0.6
Starting in early 1999, we calculated the optimal FX 0.5
baskets for 2,710 different 60-day windows. In total our 40
optimiser ran through more than 5 million individual 0.4
regressions. 0.3

0.2 20
Regression fit. Given that our variable selection
procedure has been designed to maximise the in-sample 0.1 10
fit, it is interesting that the fit is often quite poor. The R- 0 0
squared appears to be quite variable over time, and for 99 00 01 02 03 04 05 06 07 08 09 10
lengthy periods it is virtually impossible to replicate the Source: GS Global ECS Research

Chapter 7 38 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

% Improved Fit in Proxy Baskets on High Target $ basket

Poor Long-term Performance of Proxy
Asset Volatility returns
0.9 10000 Basket
Rolling R-squared of 9000
0.8 optimised baskets (LHS) Optimised Proxy FX Basket (01/06/2009)
8000 150%
Copper Spot Copper, 1st nearby future
0.6 100%
5000 50%
0.3 0%
0.2 2000
0.1 1000 Optimisation w indow
0 0 -100%
99 00 01 02 03 04 05 06 07 08 09 10 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

important in 2007 and 2008, when realised copper with a good fit (R2 = 44.4%) and plotted it against the
volatility wasn’t that high but the consistently good fit of target asset. As was to be expected, both track each other
the FX models appeared to be linked to the high levels of quite closely but then diverge very rapidly within days of
copper prices. leaving the estimation window.

To explain this pattern, it may be useful to think in terms And when looking over a much longer horizon, it
of signal-to-noise ratios. With many factors affecting FX becomes clear that the proxy basket is anything but a
markets simultaneously, it may just be that for most of proxy basket outside the optimisation sample. Another
the time commodities do not really play a major role. way to illustrate this is by looking at the correlation in
Other factors such as capital flows or rate differentials returns, which by construction is very high at +50% for
may matter more. However, when the ‘signal’ becomes the in-sample period (60 days to 1/6/2009) but, overall,
really strong, meaning that copper prices become really the rolling 60-day correlation between this specific basket
volatile or reach new highs, rapid adjustments in and copper prices only averages about +14% since 1999.
macroeconomic expectations may follow—and hence
copper (or other assets highly correlated with copper) This instability is a standard result of over-fitted models
starts to become a dominating factor in FX markets. and very much expected given our approach. One reason
why this occurs is the instability of coefficient estimates,
Out-of-Sample Robustness. Despite some regularities of which we will discuss in the next section.
R-squared, it is important to highlight that the in-sample
fit has no strong bearing on the out-of-sample fit. In other Basket composition. When looking at the composition
words, it is quite likely that after extensive optimisation of the optimal baskets through time, individual currencies
an investor will find that the ideal basket of the last three frequently enter and drop out of the baskets, and also
months has very little value going forward. To illustrate appear frequently on either the short or the long side of
this, we have chosen one of the baskets in recent months the baskets. This instability of the basket composition can

basket Poor Out-Of-Sample Performance of Estimated EUR Coefficients in All

returns the Proxy Basket FX Proxy Baskets
80% 10

20% 0
0% Optimisation w indow
Optimised Proxy FX Basket (01/06/2009) -8
Copper, 1st nearby future
-40% -10
Jan-09 Mar-09 May-09 Jul-09 Sep-09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 7 39 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Estimated AUD Coefficients in All include all optimisation results with an R-squared of at
FX Proxy Baskets least 40%, which corresponds to about 423 baskets.
These are the best 16% windows, with each basket also
8 representing the best possible variable combination for its
6 period as discussed above.
The table summarises how often a currency appears on
2 the long or short side of these well-fitting proxy baskets.
0 While the AUD, CLP and BRL are among the most
frequently appearing variables on the long side of the
basket, they do not appear a single time on the short side,
as we would expect from these globally dominating
-6 industrial metals producers. On the other hand, the CHF
-8 appears to be the most frequently shorted currency apart
from the Dollar. Given that we use the Dollar as
99 00 01 02 03 04 05 06 07 08 09 numeraire for all crosses, it implicitly appears in all
Source: GS Global ECS Research regressions and its basket weight is the difference
between estimated long and short positions in the basket.
be illustrated by plotting the changing coefficients
through time. As one example, the chart shows the Interestingly, we find that even in the selected baskets
estimated coefficient of the EUR, indicating that there is with an R-squared above 40%, most currencies display
essentially no regularity in the relationship—something unstable signs. For example, the MXN appears in 34
we would expect in an over-fitting exercise. baskets on the short side but in 42 baskets on the long
side. This is a further indication of likely out-of-sample
But some currencies also appear very systematically with instability, as discussed above.
the same sign in the different proxy baskets, such as the
AUD (see above). Moreover, the coefficient for the AUD Turning back to the robust basket components, such as
also appears to remain typically within a fairly narrow the AUD or CLP, it is interesting that the coefficients still
range. This suggests that there is more than just a change significantly—even though they remain
spurious relationship between the AUD and copper. consistently on one side of the basket. For example, the
CLP coefficients in our best-fitting baskets vary between
5.2 and 0.3. This means that the basket composition
Basket Composition for Baskets with a Good Fit likely needs frequent adjustment—even when focusing
There is very little value in analysing FX baskets that do on those components that in the past have reliably
not offer a decent fit to the target asset. We will therefore occurred on one side of the basket only.
look more specifically at the composition of well-fitting
baskets. We use a cut-off point in R-squared terms to To assess the coefficient stability, we have plotted the
decide whether or not we are interested in the individual estimated coefficients for every cross through time in the
optimised currency basket composition. After eyeballing Appendix.
the R-squared distribution shown above, we decided to
Clusters of coefficient stability. Despite these
Selection Frequency for Copper Proxy Basket* overwhelming signs of instability, there seem to be
Short Long Net Total clusters of coefficient stability as well. For example,
AUD 0 205 205 205 when zooming in on the AUD coefficients for the best
CLP 0 105 105 105
CAD 12 81 69 93 Estimated AUD Coefficients
ZAR 1 59 58 60 in FX Proxy Baskets with R2>40%
NZD 4 52 48 56 1
BRL 0 47 47 47
PLN 3 45 42 48
SEK 21 48 27 69 0
NOK 9 32 23 41
KRW 31 47 16 78 -0.5
GBP 3 18 15 21
TRY 40 50 10 90 -1
MXN 34 42 8 76 -1.5
EUR 41 31 -10 72
JPY 48 31 -17 79 -2
RUR 58 27 -31 85 Long postion in the proxy basket
CHF 87 16 -71 103 -2.5
USD 375 48 -327 423
* Baskets w ith an R2 of at least 40%
Jan-09 Mar-09 May-09 Jul-09
Source: GS Calculations Source: GS Global ECS Research

Chapter 7 40 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

baskets, we can identify a period in 2008 when the All told, when using FX proxy baskets, the quality of the
coefficient barely changed. In this and in a number of fit and the stability of coefficients has to be checked
other cases, these clusters have lasted several months. We continuously and basket weights may have to be adjusted
also note that these clusters correspond to the periods frequently. Yet even with the best precautions, out-of-
when copper prices either reached record highs or sample performance may be very poor.
displayed a lot of volatility, as discussed above.
That said, there are periods when highly optimised FX
proxy baskets do make sense, in particular when the
Conclusion: FX Proxy Baskets Do Occasionally Work target assets display high degrees of volatility or breaks
Having pursued a deliberate over-fitting strategy to above established price ranges. Moreover, fundamentally
replicate copper prices with FX proxy baskets, we related currencies display the best coefficient stability
conclude the following: and appear most frequently in the best-fitting proxy
Even with the very best over-fitting procedure, short
sample sizes and when willingly sacrificing out-of- In practical terms, over-fitted cross-asset proxy baskets
sample stability, it often appears impossible to probably work better than statistical analysis would
construct well-fitting FX proxy baskets. suggest. This is because investors will be most inclined to
use them when the target asset is ‘on the move’—and this
However, the chances of finding a useful proxy FX
is precisely when proxy FX baskets tend to perform best.
basket grow substantially when the target asset is ‘on
the move’, as indicated by increased volatility in the Most of the results in this piece depend on the choice of
target asset or relatively high price levels compared the proxy assets, which in this case were spot copper
with the past. prices. Any conclusions therefore may not hold for other
target assets. That said, preliminary tests for other target
The degree of coefficient instability is very high, as
assets suggest most of the results are comparable.
expected, and yet some currencies display a lot more
regularity, in particular in terms of the coefficient
Thomas Stolper

Those currencies that show the best coefficient

stability are also those that have the strongest
fundamental links to the target assets.

Despite all the expected instability, there are clusters

of coefficient stability lasting several months at a time.

Chapter 7 41 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Estimated AUD Coefficients in All Estimated AUD Coefficients
FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated CHF Coefficients Estimated CHF Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2

-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated GBP Coefficients Estimated GBP Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 7 42 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Estimated MXN Coefficients Estimated MXN Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2

-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated PLN Coefficients Estimated PLN Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2

-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated TRY Coefficients Estimated TRY Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 7 43 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Estimated BRL Coefficients Estimated BRL Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2

-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated CLP Coefficients Estimated CLP Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10

8 8

6 6

4 4

2 2

0 0

-2 -2

-4 -4

-6 -6 Long postion in the proxy basket

-8 -8

-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated JPY Coefficients Estimated JPY Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 7 44 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Estimated NOK Coefficients Estimated NOK Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2

-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated RUB Coefficients Estimated RUB Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated ZAR Coefficients Estimated ZAR Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 7 45 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Estimated CAD Coefficients Estimated CAD Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2

-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated EUR Coefficients in All Estimated EUR Coefficients

FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated KRW Coefficients Estimated KRW Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 7 46 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Estimated NZD Coefficients Estimated NZD Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8
6 6
4 4
2 2
0 0
-2 -2

-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated SEK Coefficients Estimated SEK Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Estimated USD Coefficients Estimated USD Coefficients

in All FX Proxy Baskets in FX Proxy Baskets with R2>40%
10 10
8 8

6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
99 00 01 02 03 04 05 06 07 08 09 99 00 01 02 03 04 05 06 07 08 09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 7 47 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chapter 8: FX Volatility Still Looks Expensive Relative to

Cyclical Factors
FX volatility still looks high when taking into account current cyclical factors. As the economic slowdown gives
way to a modest expansion, cyclical forces should support further downside in realised FX volatility. Implied
1yr FX volatility has declined only moderately and is still at high levels. As realised volatility starts to converge
towards its cyclical norms, 1yr implied volatilities are likely to follow suit.

FX Volatility Still Looks Expensive Lastly, Dollar weakness has correlated strongly with
FX volatility has peaked. Ever since the extreme FX risky asset outperformance. In other words, both EUR/$
shifts of late 2008, moves in FX markets have been more and $/EM crosses have co-moved heavily with the SPX
orderly and incremental. We think the fact that this shift on average, with strong SPX performance coinciding
in volatility has coincided with the bottoming of the cycle with broad Dollar weakness. The net result of this
is no coincidence. We have long held the view that there correlation structure has been the compression of
is a cyclical element to FX volatility. EUR/EM volatility relative to broader volatility trends.

In December 2008 we carried out a simple benchmarking

FX Volatility Has Overshot Cyclical Norms
of realised volatility relative to cyclical factors. We
Volatility has picked up substantially relative to early
argued back then that FX volatility levels were too high.
2007. Chart 1 displays monthly average 1yr realised
We also argued that a moderation in the pace of
volatility for the EUR and JPY. This G3 FX volatility
economic decline would support an even more marked
metric has picked up from a bottom of about 6.4% in July
decline in volatility.
2007 to a current level of 16.6%, the highest in the data
Since then, 1yr realised volatility coefficients have history. Faster-moving measures of realised volatility
remained high—partly because they include data from have started to decline, indicating that 1yr realised
Q4 2008. But implied volatilities have also remained at volatility should also moderate in the months to come.
very high levels of close to 14%. This raises the question
As we discussed in our 2006 work on the subject, there is
of how these levels fare relative to current cyclical
a cyclical element to volatility shifts. In Global
Economics Weekly 06/31, we noted that FX volatility
We have applied the same framework used in December tends to be higher as growth declines and the output gap
to current fundamentals. Relative to the current cyclical shifts from positive to negative. However, as growth
backdrop, an average of EUR/$ and $/JPY 1yr volatilities recovers, volatility tends to decline significantly.
should trade lower. Our analysis also suggests that
Although the cyclical environment has supported higher
cyclical forces should continue to support declining
volatility, realised volatility has significantly overshot the
volatility until much later in the cycle.
levels that current cyclical dynamics would imply are
A weaker Dollar has also supported the reduction in fair, as illustrated in Chart 1. The fitted value of a simple
emerging market (EM) FX implied volatility. We expect the framework that adjusts volatility to cyclical factors has
Dollar to remain on the weak side for the next six months. picked up to levels not seen since the early 1980s.
Together with the trends in broad FX volatility space, this However, realised volatility has increased to
should also support further declines in EM FX volatility. unprecedentedly high levels. As a result, the deviation
between the two is the largest on file.
Chart 1: 1yr Implied Vols Correcting From Extremes Chart 2: FX Volatility Drops At
But Still High Relative to Cyclical Backdrop Times of Growth Below Capacity
3 18 1.0
% 3 mth vol during phase - average
vol across phases Avg. EUR+JPY
2 16

1 0.2
10 -0.2

8 -0.6
-2 Deviation From Cyclical Volatility (lhs) 6
Output Gap:
$/JPY and $/DEM Avg 1y Implied Vol (rhs) -1.0
-3 4 Positive and Positive and Negative and Negative and
76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Rising Falling Falling Rising
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 8 48 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Chart 3: Cyclical Forces Should Support Chart 5: Gap between 1yr Realised and 1yr Implied
a Decline in Volatility % vol Vol in G3 Reflects Reduction in Short-term Vol
EUR/$ and $/JPY 1y Realized Vol 7
G3 Implied - Realized
Cyclical Fitted Value 1yr FX Vol

13 3

11 1

3 -5
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 98 99 00 01 02 03 04 05 06 07 08 09
Source:GS Global ECS Research Source: GS Global ECS Research

How do we account for the cyclical drivers of volatility? However, comparing G3 implied FX volatility to our
We regress an average of 1yr realised volatility in EUR/$ own measure of ‘cyclical volatility’, we find there is still
and $/JPY on the following US-based variables: 1) room for implied volatilities to decline by about 3 points
changes in the unemployment rate, 2) real 1yr interest to align with current cyclical fundamentals. In addition,
rates, 3) core inflation and inflation volatility, and 4) cyclical fundamentals are likely to improve, compressing
3mth rates volatility. We find that increases in the implied vols further.
unemployment rate, higher real interest rates and higher
inflation / short rates volatility tend to boost FX volatility It is not as easy to place EM FX volatility in a framework
as well. Our coefficients are statistically significant. like the one we used for G3, given that there are only a
few years of floating exchange rate history for emerging
Our results imply that as the unemployment rate, real currencies. Up until the late 1990s, most currencies were
interest rate, policy rates volatility and inflation start to either pegged or heavily managed, and a number of them
fall, so will realised FX volatility. In other words, were experiencing high inflation.
according to our macro forecasts, cyclical forces should
support an outright decline in realised volatility to about Nevertheless, in a comparison between our metric of JPY
11%, as Chart 3 shows. and EUR realised volatility trends and a similar metric
including a wide set of EM currencies, we observe that
That said, 1yr realised volatility measures do not fully the two measures have followed similar broad trends over
reflect the decline that we have already observed in the past 10 years. EM FX realised volatility appears to be
shorter-term volatility and implied volatility measures. more erratic but the cyclical implications we established
As Charts 4 & 5 also show, 1yr implied volatility is for G10 FX volatility will likely hold for EM as well, as
trading well below realised volatility measures in both Chart 6 shows.
G3 and EM FX space.

Chart 4: Gap between 1yr Realised and 1yr Implied Chart 6: Realised Vol in EM has Followed Broadly
% vol Similar Trends to G3 Vol over last 10 yrs % vol
% vol EM Vol Reflects Reduction in Short-term Vol
20 18 24
G3 Realized 1yr Vol (Mthly Avg - lhs) 22
15 EM Implied - Realized 1yr FX Vol 16 EM Realized 1yr Vol (Mthly Avg - rhs)

10 14 18
5 12

0 10 12
-5 8

6 6
98 99 00 01 02 03 04 05 06 07 08 09
98 99 00 01 02 03 04 05 06 07 08 09 10
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 8 49 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

Dollar Direction Key in Driving the Convergence Chart 7: Dollar Decline Supported EM Vol
% vol
Convergence Towards G10 Vol USD TWI
Between EM and G10 Volatility 12
Beyond cyclical forces, shifts in implied volatility will
depend on broader risk premia across markets. Indeed, EM Vol Rising Relative to G10 Vol, 102
USD Appreciating.
spikes in risk aversion are much more important drivers
of near-term implied volatility moves. The fact that 8
EM Vol - G10 Vol 97
implied volatility is still trading wide relative to where
6 US Dollar Twi
our cyclical benchmarking argues it should trade also
reflects to some extent that the come-back in risk appetite 4 92
among market participants has been gradual. And it is
fairly hard to predict how risk appetite will shift in the 2
near term. 87
However, there is another, more predictable, component
-2 82
to implied volatility (especially in EM space), namely,
Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09
USD direction. The speed and the strength of the Dollar
rally was a bullish development for implied volatilities in Source: GS Global ECS Research

late 2008, even beyond the obvious pick-up in realised that we think this will occur with a backdrop of healthy
volatility. This is because the Dollar rally triggered the risk appetite and ongoing cyclical improvement, it will be
unwinding in levered hedges and short volatility interesting to see whether overall it will help EM
structures, and created extreme trading constraints in FX volatilities hold their ground relative to G3 vols.
volatility markets, with market participants reluctant to
sell volatility in uncertain times. In addition, given the
typical volatility skew in several EM currencies Correlations with Equities Have Suppressed
(especially high yielders), FX depreciation helped to EUR/EM Vols
mark EM implied volatilities higher. As a result, EM FX One of the most striking features of the trading
vols spiked well above G10 FX vols. environment of the last few months has been the
exceptionally high correlation between the Dollar and
Over the course of 2009 a combination of a weaker global risk appetite, where stronger risk appetite has
Dollar and stronger risk appetite helped EM FX vols coincided with Dollar weakness.
converge to G10 FX vols. Of course, given the
correlation of the USD and risk sentiment, it is hard to This market feature has kept EUR/EM volatilities low
separate the impact of each factor. That said, the intense relative to $/EM vols. The mechanics are simple. Given
short-term correlation between the Dollar and the gap the intense correlations between 1) EUR/$ and global risk
between EM and G10 FX volatility supports the sentiment, and 2) $/EM and global risk sentiment,
argument that there is a strong Dollar component in EM crossing EUR with EM neutralises a significant source of
volatilities. volatility. Although EM currencies have mostly
strengthened relative to the USD, they have either
Our views have not changed recently. We continue to remained range-bound or have weakened relative to the
expect Dollar weakness over the next six months. This EUR.
will mean that EM volatilities are likely to remain close
to G10 vols. However, we also expect a modest Dollar The chart below illustrates this point. It shows how the
rebound beyond the six-month forecasting horizon. Given correlation between the SPX and the USD TWI has been

% vol Chart 8: EM Vol Has Converged Chart 9: Correlation Between USD and Risk
Towards G10 Vol Sentiment Has Kept EUR/EM Vols Low
31 0.8 1.3
Correlation Spx w ith USD TWI
0.6 (lhs) 1.3
G10 1yr Implied Vol EUR/EM 3m Implied Vols vs
26 EM 1yr Implied Vol 0.4 USD/EM (rhs) 1.2

0.2 1.2
0.0 1.1

-0.2 1.1
-0.4 1.0

11 -0.6 1.0

-0.8 0.9
EM includes BRL, TRY and INR
6 -1.0 0.9
98 99 00 01 02 03 04 05 06 07 08 09 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09
Source: GS Global ECS Research Source: GS Global ECS Research

Chapter 8 50 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

strongly negative and how that trend has co-existed with

EUR/EM underperformance of vols.

Our core views for the year ahead imply broader EM FX

strength. Long EM positions relative to the EUR
potentially enjoy a lower volatility and cost. However,
should current correlations persist, crossing the EUR
means missing out of significant upside from ongoing
risk appetite improvement. Therefore, it is mostly those
portfolios that already have significant exposure to risky
assets that will likely benefit the most from such a trend.

Inversely, if current correlations break, EM volatility

relative to the EUR could pick up significantly.

Cyclical Forces Still Support Vol Downside

FX volatility has peaked. We think the fact that this shift
in volatility has coincided with the bottoming of the cycle
is no coincidence. Our analysis shows that cyclical forces
continue to support volatility downside.

Adjusting current realised volatility levels to cyclical

factors, we find that EUR/$ and $/JPY 1yr vols should be
trading close to 11%, lower than current levels of about
14%. And as the cyclical backdrop continues to improve,
volatility could decline even further.

A weaker Dollar has supported the reduction in EM FX

implied volatility as well. We expect the Dollar to remain
on the weak side for the next six months. Together with
the trends in broad FX volatility space, this should also
support further declines in EM FX volatility.

Lastly, Dollar weakness has correlated strongly with

risky asset outperformance. This has resulted in a
compression of EUR/EM volatility relative to broader
volatility trends.

Themistoklis Fiotakis

Chapter 8 51 October 2009

Goldman Sachs Global Economics, Commodities and Strategy Research The Foreign Exchange Market

We, Dominic Wilson, Thomas Stolper, Themistoklis Fiotakis, Fiona Lake, Roman Maranets, Malachy Meechan, Anna Stupnytska, Mark Tan and Swarnali Ahmed, hereby certify
that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firm's business or client

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October 2009
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Amanda Sneider# 1(212)357-9860 Erik F. Nielsen~ 44(20)7774-1749 Noah Weisberger~ 1(212)357-6261
Roman Maranets* 1(212)357-6107
US Credit Strategy Research Economics Research Aleksandar Timcenko* 1(212)357-7628
Charles Himmelberg~ 1(917)343-3218 Ben Broadbent~ 44(20)7552-1347 Kamakshya Trivedi* 44(20)7051-4005
Alberto Gallo* 1(917)343-3214 Rory MacFarquhar~ 7(495)645-4010
Lotfi Karoui# 1(917)343-1548 Ahmet Akarli* 44(20)7051-1875
Annie Chu^ 1(212)357-5522 Kevin Daly* 44(20)7774-5908 Commodities Research
Javier Perez de Azpillaga* 44(20)7774-5205 Jeffrey Currie~ 44(20)7774-6112
Asia Dirk Schumacher* 49(69)7532-1210
Kathy Matsui~ 81(3)6437-9950 Natacha Valla* 33(1)4212-1343 Energy
Anna Zadornova# 44(20)7774-1163 Samantha Dart* 44(20)7552-9350
Asia-Pacific Economics Research Nick Kojucharov^ 44(20)7774-1169
Michael Buchanan~ 852()2978-1802 Adrian Paul^ 44(20)7552-5748 Non-Energy
Enoch Fung* 852()2978-0784 Jonathan Pinder^ 44(20)7774-1137 Janet Kong~ 852()2978-6128
Goohoon Kwon* 82(2)3788-1775 John Baumgartner# 1(212)902-3307
Tushar Poddar* 91(22)6616-9042
Helen (Hong) Qiao* 852()2978-1630 Portfolio Strategy Research Commodity Strategy
Pranjul Bhandari# 852()2978-2676 Sharon Bell* 44(20)7552-1341 Allison Nathan~ 1(212)357-7504
Keun Myung Kim# 82(2)3788-1726 Jessica Binder* 44(20)7051-0460 David Greely* 1(212)902-2850
Yu Song# 852()2978-1260 Gerald Moser# 44(20)7774-5725 Damien Courvalin# 44(20)7051-4092
Shirla Sum^ 852()2978-6634 Christian Mueller- Stefan Wieler# 44(20)7051-5119
Professor Song Guoqing 86(10)6627-3021 Glissmann# 44(20)7774-1714
Anders Nielsen# 44(20)7552-3000 Administration
Japan Economics Research Matthieu Walterspiler^ 44(20)7552-3403 Lewis Segal~ 1(212)357-4322
Tetsufumi Yamakawa~ 81(3)6437-9960 Linda Britten* 44(20)7774-1165
Chiwoong Lee* 81(3)6437-9984 Paul O'Connell* 44(20)7774-1107
Yuriko Tanaka* 81(3)6437-9964 Loretta Sunnucks* 44(20)7774-3223

Willem Buiter 44(20)7774-2731
~MD * VP/ED #Associate ^Research Assistant/Analyst Email: firstname.surname@gs.com

October 2009