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Global FX Strategy

July 13, 2011

STRICTLY PRIVATE AND CONFIDENTIAL

Introduction
Introduction to
to Foreign
Foreign Exchange
Exchange

John
John Normand
Normand
Managing
Managing Director
Director
Head,
Head, Global
Global FX
FX Strategy
Strategy
+44
207
325
5222
+44 207 325 5222
john.normand@jpmorgan.com
john.normand@jpmorgan.com
www.morganmarkets.com/GlobalFXStrategy

Agenda

I. Size, structure and management of global currency markets

Size and structure of global forex markets


Dollar-centrism
 Making more reserve currencies
 Currency regimes by 2020



II. Fundamental drivers of exchange rates

11

III. Modelling and forecasting exchange rates

18

IV. Common trading strategies for investors

32

V. Managing FX hedge ratios for investors and corporates

42

VI. Appendices

62

INTRODUCTION TO FOREIGN EXCHANGE

Size and structure of global forex markets


Average
Average daily
daily turnover
turnover in
in FX
FX spot,
spot, forwards,
forwards, swaps
swaps and
and
options
options
$bn,
$bn, based
based on
on BIS
BIS Triennial
Triennial Central
Central Bank
Bank Survey
Survey

 Forex markets are unique from four perspectives


 Liquidity: deepest market in the world
 Trading hours: continuously from Sunday evening

4500

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

4000
3500

spot

forward

swaps

(Auckland) to Friday night (New York)

options

 Structure: largely over-the-counter

3000
2500

 Government intervention: frequent, but more in

2000

emerging markets FX than in major currencies

1500

 $4 trillion in average daily turnover across all

1000

products, but dominated by spot (37% of total) and


swaps (44%). Forwards and options comprise 12%
and 6 % of turnover, respectively.

500
0
1998

2001

2004

2007

2010

Geographic
Geographic distribution
distribution of
of global
global forex
forex turnover
turnover
%
total
turnover
in
each
center,
based
on
BIS
% total turnover in each center, based on BIS survey
survey

 FX is the most liquid market in the world. For

comparison, daily turnover in equities (cash and


futures) averages $150bn for the S&P500, $ 20bn
for Nasdaq, $40bn for Dax, $16bn for FTSE and
$13bn for Nikkei.

Other
20%
UK
37%

Australia
4%
Singapore
5%
Hong Kong
5%
Switzerland
5%

 London accounts for 37% of turnover, or twice the

USs volume. Other centres account for 5% or less of


global volume.
Japan
6%

US
18%

INTRODUCTION TO FOREIGN EXCHANGE

Forex markets are disproportionately dollar-centric


 Currency markets are disproportionately USD-

Currency
Currency distribution
distribution of
of global
global turnover
turnover
Percentage
share
of
average
daily
Percentage share of average daily turnover
turnover

centric as legacy of Bretton Woods.

90%
70%

though US constitutes only 25% of the global


economy. This figure has fallen only 5 points (from
90%) since 2001

60%
50%
40%

 60% of central bank reserves are still held in USD,

30%

though this share is down from over 70% in 1999.

20%
10%

 Chinese renminbi is grossly underrepresented in

global markets relative to the Chinese economys size.

CNY

RUB

INR

MXN

NOK

SGD

KRW

NZD

SEK

HKD

CAD

CHF

AUD

GBP

JPY

EUR

USD

0%

Daily
Daily turnover
turnover versus
versus nominal
nominal GDP
GDP
Average
daily
turnover
for
Average daily turnover for specified
specified currency
currency versus
versus all
all other
other
currencies
currencies
1400

71%

USD

70%

1000

60.7%

60%

800
EUR
600

USD

50%

EUR

40%
JPY

400

GBP

30%

CAD

20%

AUD

200
0
-200

Currency allocation
allocation of
of global
global central
central bank
bank reserves
reserves
Currency
as
%
of
total,
according
to
IMF
COFER
report
as % of total, according to IMF COFER report
80%

y = 0.07x - 31.44
2
R = 0.88

1200
average daily FX turnover

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

 USD is used in 85% of forex transactions even

85% of FX transactions
involve the dollar

80%

CNY
5,000

10,000

15,000

10%
99

nominal GDP, $bn

INTRODUCTION TO FOREIGN EXCHANGE

26.6%
18%

00

01

02

03

04

05

06

07

08

09

10

11

12

despite 40 years of floating currencies and more diversified trade patterns


Timeline
Timeline for
for moving
moving from
from fixed
fixed or
or managed
managed to
to floating
floating exchange
exchange rates
rates
Trajectory
roughly
approximates
USD
real
effective
exchange
Trajectory roughly approximates USD real effective exchange rate
rate since
since 1971
1971
1985
NZD floated
(from basket
management)
TRY devalued
1999
BRL devalued

2002
ARS
devalued

1983

1998

AUD floated (from


GBP peg)

RUB devalued, MYR repegged

1970

1997

CAD
depegged
from USD

THB, MYR, IDR, PHP, KRW


& TWD devalued; ILS no
longer managed against
basket

2010

INTRODUCTION TO FOREIGN EXCHANGE

2010

2007

2004

2001

1998

1995

1992

1989

1986

1983

CNY refloated, VEB


devalued and
re-pegged to
USD

1980

1977

2007
KWD peg switched
from USD to a
basket

MXN devalued

Series of mini USD


devalutions versus major
currencies

1974

2005
CNY floated, then
repegged in 2008;
MYR floated

1994

August 1971 - March 1973

1971

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

2001

The dollars dominance has been declining for a decade, but only glacially
Currency allocation
allocation of
of global
global central
central bank
bank reserves
reserves
Currency
as
%
of
total,
according
to
IMF
COFER
report
as % of total, according to IMF COFER report

 Any currency can serve as a reserve asset if it is

liquid, convertible and stable.

80%
71%

 USDs dominance has been declining for a decade, but

70%
I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

only glacially

60.7%

60%

 Transaction demand: USD was involved in 90% of

USD

50%

forex transactions in 2001, compared to 85% in 2010

EUR

40%
30%

 Reserve demand: USD accounted for 71% of global

26.6%

reserves in 1999, compared to 61% in 2011


EUR and minor currencies (commodity FX, Scandis)
have gained market share

18%

20%
10%
99

00

01

02

03

04

05

06

07

08

09

10

11

12

Currency
Currency allocation
allocation of
of global
global central
central bank
bank reserves
reserves to
to
currencies
currencies other
other than
than USD,
USD, EUR,
EUR, GBP
GBP and
and JPY
JPY
as
as %
% of
of total,
total, according
according to
to IMF
IMF COFER
COFER report
report

Reserve diversification
diversification accelerating
accelerating
Reserve
Central bank
bank reserve
reserve accumulation
accumulation versus
versus foreign
foreign official
official
Central
purchases
of
US
securities.
USD
bn,
3-month
moving
average.
purchases of US securities. USD bn, 3-month moving average.

6%

250

5%

200

4.8%

4%

150

3%

100
2%

2%

gap between reserve accumlation and official


purchases of US securities proxies reserve
diversification

50
0

1%

-50

0%
99

00

01

02

03

04

05

06

07

08

09

INTRODUCTION TO FOREIGN EXCHANGE

10

11

03

04

05

06

07

08

09

-100

foreign official purchases of US securities

-150

global reserve accumulation

10

11

Making more reserve currencies


Government
Government bond
bond markets
markets with
with more
more than
than $100bn
$100bn of
of
outstanding
outstanding debt
debt
Government
Government bonds
bonds outstanding
outstanding with
with maturity
maturity above
above 12mos
12mos

 Reserve currencies must be liquid, convertible and

stable

6,000

 Many currencies retain value, but few will every offer

sufficient liquidity and convertibility to the worlds


largest asset managers and sovereign wealth funds

4,000
3,000
2,000

 Only four govt bond markets offer outstandings

1,000

>$1trn; only four have outstandings > $250bn


 Liquidity, diversification and AAA credit quality

Denmark

Poland

Mexico

Portugal

Australia

India

Brazil

Korea

Netherlands

Canada

China

UK

Germany

France

Italy

Euro area

Japan

US

are irreconcilable in an era of high G-10 deficits

Government
Government bond
bond markets
markets with
with less
less than
than $100bn
$100bn of
of
outstanding
debt
outstanding debt
Government
Government bonds
bonds outstanding
outstanding with
with maturity
maturity above
above 12mos
12mos

Worlds
Worlds largest
largest holders
holders of
of forex
forex reserves
reserves
FX
reserves
in
$bn
FX reserves in $bn
3500

100

3000

80

2500

60

2000

40

1500
1000

20

500

INTRODUCTION TO FOREIGN EXCHANGE

Malaysia

Mexico

Algeria

Thailand

Euro area

Switzerland

Singapore

Hong Kong

India

Korea

Brazil

Norway

Taiwan

Saudi

Russia

China
6

Japan

Chile

Egypt

Philippines

Hong Kong

Peru

Russia

New Zealand

Hungary

Colombia

Poland

Hungary

Czech Rep

Indonesia

Singapore

Thailand

Turkey

Malaysia

South Africa

Finland

0
Sweden

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

5,000

The SDR is not an alternative world currency


Weightings
Weightings of
of the
the IMFs
IMFs Special
Special Drawing
Drawing Rights
Rights (SDR)
(SDR) vs
vs
other
USD
indices
other USD indices

 The IMFs Special Drawing Rights (SDR) has been

proposed as an alternative reserve asset

100%
Other
I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

80%

 SDR isnt a currency. It is a potential claim on the

JPY

freely usable currencies of IMF members.

GBP
60%

EUR

 Value is based on weighted average of USD

USD

40%

(41.9%), EUR (37.4%), GBP (11.3%) and JPY


(9.4%). Unsurprisingly, performance mirrors DXY.

20%

 CNY excluded because it isnt fully convertible.


0%
SDR 2000

SDR
2005

SDR 2010

DXY

 Practicalities of expanding the SDRs role

JPM USD
Index

 Easy: Any investor could replicate the SDR or hold

SDRs
SDRs value
value tracks
tracks DXY
DXY closely
closely
SDR
vs
DXY
indexed
SDR vs DXY indexed to
to 100
100 in
in 1970
1970
170

an expanded version of it. There is no need to await


the IMFs imprimatur.

20

160

SDR, lhs

150

DXY inverted, rhs

140
130

40

 Hard: IMF could issue bonds payable in SDR to fund

60

its lending, but issuance would be limited compared


to sovereigns.

80

120
110

100

100

120

90
80

140
70

75

80

85

90

95

00

INTRODUCTION TO FOREIGN EXCHANGE

05

10

China as a reserve currency: rivaling the yen in a decade, and the euro in two
Daily
Daily turnover
turnover versus
versus nominal
nominal GDP
GDP
Average
daily
turnover
for
Average daily turnover for specified
specified currency
currency versus
versus all
all
currencies
currencies

 The renminbi is grossly underrepresented in global

forex markets in terms of transaction demand and


reserve allocation

1400
y = 0.07x - 31.44
2
R = 0.88

average daily FX turnover

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

1200

USD

 The main limitation is exchange controls

1000

 The renminbi could rival the yen in 10 years as

800
EUR

turnover rises to the level predicted by the size of


Chinas economy.

600
JPY

400

GBP
CAD

0
-200

 The renminbi couldnt rival the euro for at least two

AUD

200

CNY
5,000

decades given Chinas relatively small debt market.


10,000

15,000

nominal GDP, $bn

USD/CNY
USD/CNY vs
vs USD/CNH
USD/CNH 12-mo
12-mo forward
forward outright
outright rate
rate
6.9
CNY 12mo outright

6.8

CNH 12mo outright

6.7

Renminbi deposits
deposits with
with Hong
Hong Kong
Kong Banks
Banks
Renminbi
CNY
billion
CNY billion
600
500
400

6.6

300

6.5
6.4

200

6.3

100

6.2
Jan-10

May-10

Sep-10

Jan-11

INTRODUCTION TO FOREIGN EXCHANGE

May-11

04

05

06

07

08

09

10

11

Advantages and disadvantages of reserve currency status


 Advantages
 Lower interest rates due to substantial foreign demand for countrys government bonds.

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

 Probably worth 50bp in the US


 More important for debtor countries like the US than surplus countries such as China.
 Higher sovereign credit rating due to financing flexibility from a dedicated investor base.
 Ratings agencies fail to see the circularity of this issue but nonetheless cite the dollars reserve

currency dominance as justifying a high rating.


 Less exchange rate risk for corporates since international trade is invoiced in their home currency.
 Disadvantages
 Stronger currency than what otherwise would prevail.
 More important for open economies like Switzerland and China than relatively closed ones like the

US
 The winners from a loss of the dollars reserve status will be European and Chinese corporates
 The losers will be US borrowers (government and corporates) due to higher interest rates, and USD-

based corporates due to less invoicing in dollars.

INTRODUCTION TO FOREIGN EXCHANGE

Currency regimes by 2020 more fixed or floating?

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

Currency
Currency regimes
regimes and
and implied
implied volatility
volatility
Annualised
Annualised daily
daily volatility
volatility over
over the
the past
past year
year in
in parentheses
parentheses for
for specified
specified currency
currency versus
versus USD
USD for
for all
all currencies
currencies but
but GBP,
GBP, SEK,
SEK, NOK,
NOK,
CHF,
DKK
and
CEEMEA,
which
are
quoted
versus
EUR
CHF, DKK and CEEMEA, which are quoted versus EUR

More managed

Less managed

(lower volatility, higher event risk)

(higher volatility, less event risk)

Fixed

Officially floating

Officially floating

Officially floating
(occasional intervention)

(frequent intervention)

(rare intervention)

AED (0.25%) HKD (0.75%)

BRL(13.1%) ILS (7.2%)

JPY (10.2%) PHP (7.4%)

USD

SAR (0.2%)

LVL (1.1%)

CNY (1.8%)

CHF (9.8%)

MYR (7.7%)

EUR (12.1%) HUF (11.1%)

BHD (0.1%)

DKK (0.25%)

KRW (12.7%) CLP (11.2%)

INR (7.6%)

ZAR (12.3%)

GBP (9.5%)

QAR (0.3%)

BGN (.25%)

TWD (4.9%)

PEN (1.8%)

MXN (10.8%) TRL (12.1%)

AUD (14 .2%) RON (4.5%)

KWD (3.2%)

VEB (0%)

THB (4.3%)

ARS (4.3%)

ISK (10.8%)

NZD (14 .1%)

OMR (0.2%)

JOD (2.8%)

IDR (6.7%)

RUB (8.8%)

CAD (11.1%)

SGD (6%)

EGP (2.8%)

SEK (7.4%)

COP (10.6%)

NOK (8.1%)
EMU members?
China currency union?
Gulf monetary union?

INTRODUCTION TO FOREIGN EXCHANGE

10

PLN (10.5%)

CZK (6%)

EMU members?

Agenda

I. Size, structure and management of global currency markets

II. Fundamental drivers of exchange rates

11

Monetary approach
 Balance of payments approach
 Asset market approach
 Intervention


III. Modelling and forecasting exchange rates

18

IV. Common trading strategies for investors

32

V. Managing FX hedge ratios for investors and corporates

42

VI. Appendices

62

INTRODUCTION TO FOREIGN EXCHANGE

11

What drives markets? More consternation in currencies than in core asset classes
 Common perception

Annual
Annual returns
returns by
by currency
currency managers
managers
Rolling
12-mo
returns
for
currency
Rolling 12-mo returns for currency managers
managers

 Currency movements are random. They can be explained

18%

ex post but cannot be predicted.

HFR Currency Index


Barclay Currency Trader Index

13%

 Implications: For investors, currencies present no profit

opportunity. For hedgers, currencies present volatility with


no apparent trend. Those with mark-to-market constraints
should hedge. Those without should ignore currency risk,
since prices will mean revert eventually.

8%
3%
-2%

 Common frameworks
-7%
II. FUNDAMENTAL DRIVERS OF EXCHANGE RATES

02

04

06

08

 More complementary than competing.

10

 Currencies have monetary and non-monetary drivers.

Performance
Performance of
of J.P.
J.P. Morgan
Morgan model-based
model-based strategies
strategies
Rolling
12-mo
returns
Rolling 12-mo returns

 Some more appropriate for long than short term.

60%

 Monetary approach
40%

 Balance of payments approach


20%

 Asset market approach


0%

 Overlay: central bank intervention

G-10 carry
-20%

Emerging markets carry

 Regardless of framework, remember the key distinction between

Rate momentum (forward carry)

-40%
01

03

05

07

09

INTRODUCTION TO FOREIGN EXCHANGE

11

FX and other markets: FX is driven by relative fundamentals,


not absolute ones. By definition FX is a relative value market.
12

Monetary approach (purchasing power parity): currencies respond to inflation differentials


 Purchasing power parity

Drift
Drift in
in real
real exchange
exchange rates
rates undermines
undermines PPP
PPP theory
theory
J.P.Morgan
real
effective
exchange
rate
indices
for
J.P.Morgan real effective exchange rate indices for USD
USD &
& BRL
BRL
130
USD, lhs

250

 Theory: high-inflation currencies should depreciate

210

relative to lower-inflation ones through the impact


on trade balances

BRL, rhs

120
110

 Empirical evidence: very poor over the short term.

170
100

Only useful over the short term for a few


currencies, particularly hyper-inflation ones.

130
90
80

90

70

50

II. FUNDAMENTAL DRIVERS OF EXCHANGE RATES

70

75

80

85

90

95

00

05

10

USD/JPY
USD/JPY has
has fallen
fallen twice
twice as
as much
much as
as inflation
inflation differentials
differentials
imply
imply
USD/JPY
USD/JPY versus
versus cumulative
cumulative Japan
Japan
US
US inflation
inflation differential.
differential.
Both
series
indexed
to
100
in
1971
Both series indexed to 100 in 1971
140

USD/MXN
USD/MXN has
has risen
risen in
in line
line with
with inflation
inflation differentials
differentials
USD/MXN
vs
cumulative
Mexico

USD/MXN vs cumulative Mexico US


US inflation
inflation differential.
differential. Both
Both
series
indexed
to
100
in
1974.
series indexed to 100 in 1974.
140020

USD vs JPY, indexed

USD vs MXN, indexed

120020

120

JA - US inflation differential, indexed

Mexico vs US inflation differential, indexed

100020

100

80020

80
60020

60

40020

40

20020

20

20

71

76

81

86

91

96

01

INTRODUCTION TO FOREIGN EXCHANGE

06

11

74

13

79

84

89

94

99

04

09

Balance of payments approach: focus on particular current and capital account components
 Balance of payments approach

Balance
Balance of
of payments
payments for
for 2010
2010
All
figures
in
billions
of
USD
All figures in billions of USD

II. FUNDAMENTAL DRIVERS OF EXCHANGE RATES

US

Euro area

Japan

Australia

 Theory: currencies driven by a range of trade and

Brazil

Current account
Trade balance
Services balance
Income
Transfers

-472
-646
145
165
-136

-48
27
54
2
-133

182
74
-14
135
-13

-48
-3
-1
-45
0

-47
20
-31
-40
3

Capital account
Portfolio investment
Financial derivatives
Direct investment
Other investment

451
552
13.7
-115
NA

59
190
11
-104
-37

-37
-8
8
-60
24

45
63
-8
19
-29

111
63
0
48
NA

-49

Change in reserves*
-1.8
-14
-59
* negative value indicates an increase in central bank reserve assets

capital flows. Trade/current account positions


determine structural bias, and capital account
components the shorter-term fluctuations. Challenge
is to identify key components, which vary by
currency and over time.
 Empirical evidence: more descriptive than

predictive; currencies are much more variable than


underlying balance of payments flows would suggest

USD/JPY
USD/JPY vs
vs US
US
Japan
Japan 1-mo
1-mo libor
libor

USD/JPY
USD/JPY vs
vs Japanese
Japanese trade
trade balance
balance
70

125
120

80

11 5

90

11 0
105

4 00

1 00

100

2 00

11 0

95
90

1 20

85

1 30

80
75

12 00
10 00
8 00
6 00

0
-2 00
Jap an ese trad e ba lan ce, JPY bn
USDJP Y in verte d

-4 00
-6 00

1 40
20 02

20 05

20 08

INTRODUCTION TO FOREIGN EXCHANGE

2007

2011
14

6 00
U S D J PY
U S - JA 1m o lib or, bp

5 00
4 00
3 00
2 00
1 00
0
- 100

20 08

2009

20 10

2 011

Asset markets approach: currencies respond to current and future fundamentals


 Asset markets approach

Balance
Balance of
of payments
payments for
for 2010
2010 in
in USD
USD bn
bn

II. FUNDAMENTAL DRIVERS OF EXCHANGE RATES

US

Euro area

Japan

Australia

Brazil

Current account
Trade balance
Services balance
Income
Transfers

-472
-646
145
165
-136

-48
27
54
2
-133

182
74
-14
135
-13

-48
-3
-1
-45
0

-47
20
-31
-40
3

Capital account
Portfolio investment
Financial derivatives
Direct investment
Other investment

451
552
13.7
-115
NA

59
190
11
-104
-37

-37
-8
8
-60
24

45
63
-8
19
-29

111
63
0
48
NA

Change in reserves*

-1.8

-14

-59

-49

AUD/USD
AUD/USD vs
vs AU
AU
US
US policy
policy rate
rate spread
spread
RBA
cash
rate
minus
Fed
funds
RBA cash rate minus Fed funds rate
rate
1.1

 Theory: Currencies arent just relative prices. They are

also assets, so follow the same principles which drive


asset markets (price = PV of future cash flows, prices
adjust instantaneously to new information about
fundamentals). Current and future fundamentals matter.
 Empirical evidence: very strong. Currencies show clear

correlation with current conditions and changes in


expectations. These relationships can be exploited
through systemic trading rules.
AUD/USD vs
vs AU
AU
US
US rate
rate expectations
expectations
AUD/USD
Rate
expectations
are
1mo
rates
12mos forward
forward
Rate expectations are 1mo rates 12mos

600

1.1

500

1.0

0.9

400

0.9

400

0.8

300

0.8

300

0.7

200

0.7

200

0.6

100

0.6

100

0.5

0.5

0.4

-1 00

0.4

-1 00

1.0

AUD/ US D
RBA cash rae t - Fe d fun ds ra te

20 02

20 05

20 08

INTRODUCTION TO FOREIGN EXCHANGE

20 11

20 02
15

600

AUD/US D
AU - US 1 mo 1 2m os fwd

20 05

500

20 08

20 11

Intervention: an overlay to fundamentals


 Central banks intervene for three reasons
 Correct a misalignment
 Central bank considers the FX rate to be far from equilibrium, and the misalignment may adversely affect

its objectives for growth, inflation or financial stability. It will therefore intervene to influence the exchange
rates level.
 Example: Bank of Japan in September 2010
 Reduce volatility

II. FUNDAMENTAL DRIVERS OF EXCHANGE RATES

 Disorderly FX movements can destabilise other asset markets. During crises, FX moves have

bankrupted corporates. Central bank intervention can contain this volatility, improve liquidity and prevent
a market from becoming one-way.
 Example: numerous EM central banks during the Lehman crisis
 Build reserves
 Intervention by selling the domestic currency/buying the foreign currency allows a country to accumulate

reserve assets. These can be used to fund investment (a sovereign wealth fund), to insure against a
future liquidity crisis or to support the domestic currency if it should weaken excessively.
 Example: $300bn of Chinas $3trn of forex reserves are allocated to its sovereign wealth fund
 Intervention can be unilateral or coordinated, and sterilised or unsterilised

INTRODUCTION TO FOREIGN EXCHANGE

16

Only effective if backed by changes in policy or cyclical conditions


Interventions
Interventions start
start currency
currency trends
trends when
when reinforced
reinforced by
by changes
changes in
in
policy
rates
policy rates
Fed
Fed funds
funds rate,
rate, Buba/ECB
Buba/ECB refi
refi rate
rate and
and BoJ
BoJ call
call rate
rate since
since 1970,
1970, with
with
major
coordinated
and
unilateral
interventions
noted
major coordinated and unilateral interventions noted
20%

1.0

Fed funds
G3 sells
USD
(Plaza,
1985)

Buba/ECB refi
BoJ call rate

16%

USD/BRL
USD/BRL versus
versus Central
Central Bank
Bank of
of Brazil
Brazil daily
daily intervention
intervention
Intervention
Intervention in
in USD
USD bn,
bn, where
where positive
positive (negative)
(negative) value
value indicates
indicates USD
USD
purchases
(sales)
purchases (sales)

G3 buys
USD
(Louvre,
1987)

G3 buys
EUR,
2000

3.5

USDBRL, rhs

0.5

12%

4.0

USD buying (+) or selling (-) by central bank, bn, lhs

3.0

BoJ sells
JPY,
2003-04

0.0
2.5

8%

II. FUNDAMENTAL DRIVERS OF EXCHANGE RATES

-0.5

2.0

4%

-1.0

1.5
03

0%
70

73

76

79

82

85

88

91

94

97

00

03

06

04

05

06

07

08

09

10

11

09

 Successful if unsterilised or backed by a shift in monetary policy.


 Plaza Accord weakened the dollar because the Fed began easing in 1985 while the Bundesbank, and the BoJ

were on hold. Louvre Accord lifted the dollar because the Fed began tightening as the Buba eased and the
BoJ lifted rates only modestly.
 Otherwise intervention only arrests a trend briefly (intra-week).
 Bank of Japan intervention in 2003-04 and in 2011 didnt not reverse yen strength. Neither has Central Bank of

Brazil intervention since 2003.


INTRODUCTION TO FOREIGN EXCHANGE

17

Agenda

I. Size, structure and management of global currency markets

II. Fundamental drivers of exchange rates

11

III. Modelling and forecasting exchange rates

18

Different models for different purposes


 Valuation models: structural (long-term) and cyclical (short-term) approaches
 Rule-based trading models: Carry, interest rate momentum, price momentum


IV. Common trading strategies for investors

32

V. Managing FX hedge ratios for investors and corporates

42

VI. Appendices

62

INTRODUCTION TO FOREIGN EXCHANGE

18

Can FX rates be forecast?


Forecast
Forecast errors:
errors: the
the consensus
consensus has
has been
been too
too conservative
conservative in
in forecasting
forecasting USD
USD
weakness
since
2000
weakness since 2000
Consensus
Consensus error
error on
on G-10
G-10 and
and emerging
emerging market
market FX
FX forecasts
forecasts vs
vs USD,
USD, where
where error
error is
is
calculated
as
difference
between
actual
rate
and
forecast
r
ate
over
horizons
of
calculated as difference between actual rate and forecast r ate over horizons of one
one
quarter
quarter to
to two
two years.
years. A
A positive
positive (negative)
(negative) value
value indicates
indicates that
that the
the consensus
consensus
underestimated
(overestimated)
foreign
currency
strength
vs
USD.
underestimated (overestimated) foreign currency strength vs USD.

12%

calling direction than magnitude


 Forecast error = realised FX rate (t1)

vs consensus forecasts (t0)


 Positive (negative) error indicates

that consensus underestimated


foreign currency strength
(weakness) vs USD

10%
G-10 FX

8%
III. MODELLING AND FORECASTING EXCHANGE RATES

 FX forecasters have been better at

EM FX

 Zero error indicates perfect foresight

6%

 Since 2000, error has ranged from

4%

1% over one quarter to 10% over


two years.

2%

 Consensus was correct in

0%
Current qtr

1 qtr ahead

2 qtrs ahead

INTRODUCTION TO FOREIGN EXCHANGE

1 yr ahead

19

2 yrs ahead

forecasting the dollars decline but


was too conservative on the
magnitude.

Different models for different purposes


Frequency

Low (quarterly)

Intermediate (monthly)

High (daily)

Inputs

III. MODELLING AND FORECASTING EXCHANGE RATES

Fundamental

Technical

Fundamental equilibrium
exchange rate models
(structural variables)
 terms of trade
 productivity
 government debt
 net investment income

Purchasing Power Parity


inflation differentials

Daily fair value


regressions
(cyclical variables)
 Rate expectations
 Sovereign spreads
 Equity volatility
 Commodity prices

JPM model: long-term fair


value model

JPM indicator: real effective


exchange rate indicators

JPM models: Fair value


regression chartpack

Momentum
Long-term (+10yr) price
trend

Carry
 Cash rate/libor differentials

Momentum
 Rate trends
 Price trends

JPM models: NA

JPM models: IncomeFX for


G-10 carry, Income EM for
emerging markets carry

JPM models: Forward


Carry, Price momentum

Models vary by input (fundamental, technical) and frequency (high, intermediate, low)
INTRODUCTION TO FOREIGN EXCHANGE

20

Long-term models: PPP versus fundamental exchange rate models

III. MODELLING AND FORECASTING EXCHANGE RATES

Approach

Theory

Advantages

Disadvantages

Purchasing
Power Parity
(PPP)

Inflation differentials drive the


bulk of exchange rate swings.
Real exchange rates are constant,
or at least mean revert, over time.

Simple to explain, model and


implement (sell/buy
currencies which are very
expensive/cheap versus PPP
value).

In practice real exchange


rates for most currencies
trend rather than mean
revert. The choice of base
year against which to
benchmark misalignment
is arbitrary. Only relevant
for bilateral exchange
rates and ignores
multilateral interactions.

Fundamental
equilibrium
exchange rate
(FEER)

FEER vary systematically with


macroeconomic fundamentals.
Equilibrium is a multilateral not a
bilateral concept.

Accommodates the
intuitively-appealing notion
that factors other than
relative prices drive
exchange rates. Allows
simulation for how changes
in fundamentals (other than
inflation) alter a currencys
long-run equilibrium level.

More cumbersome to
estimate, and to transform
multilateral misalignments
into bilateral fair values.

INTRODUCTION TO FOREIGN EXCHANGE

21

Estimating a long-term econometric model


 J.P.Morgans REER model uses terms of trade,

Components
Components and
and interpretation
interpretation of
of J.P.Morgan
J.P.Morgan REER
REER
model
model
Variable

Coefficient

productivity, government debt and net investment


income. Panel regression for 19 currencies over 200010 sample.

Interpretation

Terms of trade

0.34

A 1% increase in terms of trade


increases REER by 0.34%

Productivity

0.58

A 1% increase in productivity
increases REER by 0.58%

Gross gov'to debt/GDP

-0.21

A 1 percentage point increase to


Debt/GDP decreases REER by 0.21%

 On a real effective basis the most overvalued are JPY,

NZD, EUR, AUD; most undervalued are USD and GBP.

Net investment income/trade

0.2

overvalued currencies are JPY, NZD, EUR; the most


undervalued is USD relative to all other currencies.

A 1 percentage point increase to


NII/trade increases REER by 0.20%

Real
Real trade-weighted
trade-weighted deviations
deviations from
from fair
fair value
value (%)
(%)
Positive
Positive (negative)
(negative) value
value indicates
indicates over
over (under)
(under) valuation
valuation

 Caveats: (1) fair value is more a range than a point; (2)

valuation requires a catalyst to force mean reversion


AUD REER
REER model
model versus
versus actual
actual
AUD
110

30%

Actual

20%

100

10%

90

0%

80

Estimatedd fair value

-10%

70

INTRODUCTION TO FOREIGN EXCHANGE

60

BRL

JPY

NZD

EUR

AUD

CHF

ZAR

NOK

SEK

MXN

CAD

PLN

KRW

CLP

GBP

TRY

CNY

-20%
USD

III. MODELLING AND FORECASTING EXCHANGE RATES

 On a nominal basis relative to USD, the most

00

22

01

02

03

04

05

06

07

08

09

10

.versus a short-term one


EUR/USD
EUR/USD high-frequency
high-frequency cyclical
cyclical model
model
EUR/USD
regressed
on
Euro
EUR/USD regressed on Euro
US
US rate
rate spreads
spreads (1-mo
(1-mo rates
rates 12mos
12mos
forward),
sovereign
spreads
(5-yr
Spain
vs.
Germany)
and
equity
forward), sovereign spreads (5-yr Spain vs. Germany) and equity
volatility
volatility (VIX).
(VIX). Positive
Positive (negative)
(negative) value
value indicates
indicates EUR/USD
EUR/USD over
over
(under)
valuation.
Daily
data
since
2008.
(under) valuation. Daily data since 2008.

Deviations
Deviations from
from fair
fair value
value using
using high-frequency
high-frequency model
model
Residual
Residual in
in cents
cents from
from EUR/USD
EUR/USD regression
regression in
in chart
chart 1.
1. Positive
Positive
(negative)
value
indicates
EUR/USD
over
(under)
valuation.
(negative) value indicates EUR/USD over (under) valuation.

Re sid ual
0. 10

Y - (-0 .000 8 X2 - 0.0 031 X3)


1 .7 5
Y = 0. 00 11 X 1 - 0.0 00 8 X2 - 0. 00 31 X3 + 1 .4 71 9
1 .7 0 R = 8 4.4 9%
sta nd ard error = 0.0 37 1
1 .6 5

QE II
0. 05
0. 00

1 .6 0
III. MODELLING AND FORECASTING EXCHANGE RATES

US de bt ceiling

1 .5 5

-0 .05
G ree ce

1 .5 0
-0 .10

1 .4 5
1 .4 0

Le hm a n

-0 .15

-5 0

50
10 0
1 50
E U - US 1m o 1 2m os fwd

20 0

250

20 08

2 00 9

2 01 0

2 011

 Similar to the long-term regressions which focus on structural factors (productivity, government debt), short-

term models focus on cyclical factors such as rate expectations, sovereign risk, commodity prices or equity
performance which can be measured daily
 If these cyclical variables well explain movements in the currency, then extreme deviations from predicted fair

value identify turning points for short-term corrections.

INTRODUCTION TO FOREIGN EXCHANGE

23

Rule-based trading models versus discretion


 Rule-based investing employs fixed rules to decide which assets to buy and sell.
 Momentum: Buy (sell) asset because it has performed well (poorly) in the past

Exploits positive serial correlation in returns


 Value: Buy (sell) asset because it is cheap (expensive)

Exploits negative serial correlation in returns

 Why rules & models?


 Investing requires systematic thinking
III. MODELLING AND FORECASTING EXCHANGE RATES

World is complex and requires quantitative balancing of many driving forces


 Trading rules perform better (though in-sample) than actual managers

Models identify low-hanging fruit, thus allowing managers to focus on the more complex issues. This
division of labor is more efficient.
 For asset managers, rules create discipline, admittedly at the price of flexibility
 For investors, RBI-structured products create cheap sources of alpha

 Why discretion & judgement?


 Markets are relatively efficient. Any systematic mispricing will be arbitraged away, thus eliminating once

profitable trading rules


 Models cannot capture full complexity of the world or structural changes.
 Making models more complex is self defeating, as it creates parameter drift

INTRODUCTION TO FOREIGN EXCHANGE

24

A few guidelines for model-based strategies


Returns on JPM FX currency models

 Much J.P. Morgan Research is hybrid

Annual returns

 Some strategists use models for baseline view, but final

60%

recommendation has discretionary overlay

40%

 J.P. Morgan approach combines pure algorithmic

20%

 Model-informed vs model-driven

recommendations with discretionary ones


 Quantitative and discretionary approaches are

0%

complementary, not opposing

G-10 carry

III. MODELLING AND FORECASTING EXCHANGE RATES

-20%

Emerging markets carry

 Guidelines for quantitative models

Rate momentum (forward carry)

-40%
01

03

05

07

 Occams razor: minimize number of parameters


09

11

 Robustness to alternative specifications


 Trading rules rather than econometrics
 Strong conceptual rationale for why the inefficiency

exists and should persist


 Absence of a large following

INTRODUCTION TO FOREIGN EXCHANGE

25

Rule-based trading models: Carry


 Intuition

Top FX carry trades: Absolute carry vs carry-to-risk


Pair

III. MODELLING AND FORECASTING EXCHANGE RATES

Long INR vs JPY


Long IDR vs JPY
Long TRY vs USD
Long ZAR vs USD
Long AUD vs USD
Long NZD vs USD
Long NOK vs USD

Absolute
carry
8.2%
7.4%
6.6%
5.6%
5.1%
2.7%
2.3%

Pair
Long IDR vs USD
Long INR vs USD
Long TWD vs USD
Long PHP vs USD
Long AUD vs USD
Long NZD vs USD
Long NOK vs USD

Carry-to-risk
ratio
2.1
1.7
0.8
0.8
0.5
0.3
0.2

information ratio on basket of top pairs based on absolute carry and


carry-to-risk

Absolute
carry

Absolute
carry

 Investors are more motivated by risk-adjusted yield

differentials than absolute ones


 Trading rule
 Buy basket of currencies offering the highest risk-

 Performance since 2000


 G-10 basket: annual returns of 5.2%, volatility of

2006-2010

Carry-to-risk
ratio

economies so attract foreign capital, thus


appreciating currencies.

adjusted carry each month (1-mo libor


spread/realised spot vol)

Returns: Absolute carry vs carry-to-risk strategy

2000-10

 High interest rates are associated with strong

8.3% and IR of 0.6.

Carry-to-risk
ratio

Top pair

1.09

0.94

0.58

0.45

Top 2 pairs

1.20

0.94

0.72

0.13

Top 3 pairs

1.32

1.45

0.58

0.91

Top 4 pairs

1.33

1.48

0.57

0.84

 EM basket: annual returns of 11.2%, volatility of

13.2% and IR of 0.8.


 Risk-adjusted carry tends to outperform absolute

carry
 Basket of top currencies outperforms top pair

INTRODUCTION TO FOREIGN EXCHANGE

26

Rule-based models: Interest rate momentum (Forward Carry)


AUD/USD
AUD/USD vs
vs AU
AU
US
US policy
policy rate
rate spread
spread
RBA
cash
rate
minus
Fed
funds
RBA cash rate minus Fed funds rate
rate
1.1

600

AUD/ US D
RBA cash rae t - Fe d fun ds ra te

1.0

III. MODELLING AND FORECASTING EXCHANGE RATES

 Intuition

400

0.8

300

0.7

200

0.6

100

0.5

0.4

-1 00
20 05

20 08

much as to static rate spreads (carry)

500

0.9

20 02

 Currencies respond to changes in rate spreads as

Most currencies appreciate (depreciate) against


others when rate rise (fall) relative to others,
regardless of a currencys initial yield.
These moves reflect shifting cyclical momentum
and/or monetary policy.
Referred to as forward carry, since FX reflects
expected carry levels in future.

20 11

AUD/USD
AUD/USD vs
vs AU
AU
US
US rate
rate expectations
expectations
Rate
expectations
are
1mo
Rate expectations are 1mo rates
rates 12mos
12mos forward
forward
1.1
1.0

AUD/US D
AU - US 1 mo 1 2m os fwd

400

0.8

300

0.7

200

0.6

100

0.5

0.4

-1 00
20 05

 Buy (sell) currencies in whose favor yields have

500

0.9

20 02

 Trading rule

600

20 08

INTRODUCTION TO FOREIGN EXCHANGE

moved recently.
 Parameters: (1) reference interest rate; (2) lookback

period for measuring change (3) rebalancing frequency


(daily, weekly, monthly)
 Performance since 2000
 Annual returns of 6.5%, volatility of 6.7% and IR of 1.

20 11
27

Rule-based models: Carry with rate momentum overlay


 Intuition

Using
Using rate
rate momentum
momentum to
to time
time the
the entry
entry to
to and
and exit
exit
from
carry
trades
from carry trades

 If currencies respond to static spreads (carry) and

changes in rate expectations (forward carry), the


strongest currencies should be high-yielders where
rates are rising. The most vulnerable are lowyielders where rates are falling.

Step 1
Rank all currency pairs in descending order of risk-adjusted carry (carry-torisk ratio)
Step 2
Eliminate pairs with carry-to-risk ratio < 0.2

 Trading rule

III. MODELLING AND FORECASTING EXCHANGE RATES

 Only hold carry where spreads are also widening in


Standard carry

Forward Overlay

Step 3a
Select top 4 pairs for inclusion
in carry basket

Step 3b
For eligible pairs, calculate the
direction of spread momentum on
the day prior to rebalancing.

Step 4a
Rebalance monthly

Step 4b
If spread momentum moving
against high-yielder, eliminate.

favor of the high-yielder


 Forward carry functions as a cyclical overlay to a

carry strategy, an approach which is conceptually


more appealing that the endogenous risk-appetite
filters common in the market
 Performance since 2000
 Annual returns of 6.6%, volatility of 8.3% and IR of 1,

which improves on the standard carry strategy.

Step 5b
Repeat until 4 eligible pairs
identified. Invest equally in each.
If < 4 pairs qualify, invest equally in
those.

INTRODUCTION TO FOREIGN EXCHANGE

28

Rule-based models: Price momentum


Conditional
Conditional probability
probability of
of consensus
consensus forecast
forecast changes
changes on
on US
US
growth
growth and
and inflation
inflation since
since 2000
2000
Probability
Probability of
of forecast
forecast change
change in
in time
time t+1
t+1 given
given change
change in
in period
period tt
Growth

 Markets exhibit momentum due to the behavioural

biases of under and over reaction

Period t+1
Period t

Up

Down

Up

0.67

0.33

Down

0.31

0.69

Inflation

 Investors under-react to information and adjust

position incrementally, thus creating trends


 Trading rule

Period t+1
Period t

Up

Down

Up

0.65

0.35

Down

0.17

0.83

 Buy (sell) currencies which have appreciated

(depreciated) recently
Overlay rate momentum (forward carry) as an
additional filter. Buy currencies which have
appreciated over past year and where rates have
risen over the past month.

Revisions
Revisions to
to consensus
consensus forecasts
forecasts on
on US
US growth
growth vs
vs S&P500
S&P500
returns
returns
Consensus
Consensus forecasts
forecasts based
based on
on monthly
monthly Blue
Blue Chip
Chip survey
survey
10%

y = 11.14x + 0.01
2
R = 0.52

monthly change in S&P500

III. MODELLING AND FORECASTING EXCHANGE RATES

 Intuition

5%

 Parameters: (1) momentum measure (simple or

exponential change in price); (2) lookback period (intraday, daily, weekly, monthly); and (3) rebalancing
frequency (daily, weekly, monthly).

0%
-5%
-10%

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-15%
-0.2% 0.0%

 Performance since 2000


0.2%

 Annual returns of 3.7%, volatility of 8.9% and IR of

0.4%

0.41

monthly change in consensus US growth forecast


INTRODUCTION TO FOREIGN EXCHANGE

29

Rule-based strategies: a summary


Returns
Returns on
on G-10
G-10 and
and emerging
emerging markets
markets carry
carry strategies
strategies
index
index levels
levels

Returns
Returns on
on G-10
G-10 momentum
momentum strategies
strategies
index
index levels
levels

350

200

300

180

250

EM Carry

160

200

140

150

III. MODELLING AND FORECASTING EXCHANGE RATES

Forward Carry
Forward Carry Overlay
Forward Momentum Overlay

G-10 Carry

100

120

50

100

80
00

02

04

06

08

10

00

02

04

06

08

10

 G-10 and emerging markets carry strategies select four currencies with highest ratio of carry (1-mo rate differential) to volatility (annualized

spot vol over past 30 days).


 Forward Carry buys the currency in whose favor rate expectations have moved over the past month. Expectations are based on 1mo rates

3mos forward.
 Forward Carry Overlay only buys high yield currencies if rate expectations are also moving in that currencys favor, so combines standard

carry and Forward Carry concepts.


 Forward Momentum Overlay only buys currencies which have appreciated in spot terms over the past year and are experiencing rising rate

expectations relative to another currency over the past month. Thus it combines the standard price momentum framework with Forward Carry.
 All strategies are described in Alternatives to Standard Carry and Momentum in FX (Normand, August 8, 2008).

INTRODUCTION TO FOREIGN EXCHANGE

30

Performance: comparable to currency managers but lower than hedge funds

III. MODELLING AND FORECASTING EXCHANGE RATES

Long-term
Long-term performance
performance of
of FX
FX rule-based
rule-based strategies
strategies compared
compared to
to performance
performance of
of fund
fund managers
managers

Rates
G-10 carry with
momentum Forward Carry
(9 USD pairs)
overlay

Price
momentum
Overlay
(9 USD pairs)

Currency manager performance


Barclay
Barclay
Currency
Parker
HFR
Blacktree currency
Group
Traders
CMI**
index*
Index*
BTOP FX**

Hedge fund performance


HFR emerging
HFR global
HFR global
market
macro hedge
macro hedge
hedge
funds**
funds*
funds*

G-10 carry
(unlevered)

Emerging
Markets carry
(IncomeEM)

2011 YTD
1H11 return
Std dev
IR

10.7%
8.5%
1.3

9.4%
10.1%
0.9

1.1%
4.9%
0.1

7.2%
8.4%
0.9

-5.3%
10.6%
-0.5

2.1%
3.6%
0.6

-3.2%
5.2%
-0.6

-5.3%
3.6%
-1.5

-1.7%
6.5%
-0.3

-4.3%
6.0%
-0.7

-4.3%
5.8%
-0.7

-0.2%
4.3%
-0.1

2010
Avg annual return
Std dev
IR

8.5%
10.8%
0.8

8.2%
9.1%
0.9

20.2%
6.9%
2.9

6.1%
8.2%
0.8

22.0%
9.5%
2.3

2.6%
3.1%
0.8

7.5%
4.1%
1.8

0.7%
3.3%
0.2

-1.3%
5.1%
-0.3

-1.7%
0.5%
-3.5

8.1%
6.9%
1.2

11.4%
9.9%
1.2

2006-2010 (5 years)
Avg annual return
Std dev
IR

1.9%
10.4%
0.2

5.8%
11.3%
0.5

13.0%
8.1%
1.6

5.9%
10.2%
0.6

10.3%
11.5%
0.9

0.2%
2.2%
0.1

1.6%
4.3%
0.4

2.7%
3.0%
0.9

1.2%
5.1%
0.2

0.2%
0.3%
0.7

6.8%
5.7%
1.2

4.5%
14.2%
0.3

2001-2010 (10 years)


Avg annual return
Std dev
IR

5.2%
8.3%
0.6

11.2%
13.2%
0.8

6.5%
6.7%
1.0

6.6%
8.3%
0.8

5.4%
10.1%
0.5

3.7%
5.0%
0.7

NA
NA
NA

NA
NA
NA

NA
NA
NA

NA
NA
NA

11.6%
5.7%
2.1

24.8%
12.3%
2.0

* monthly return composites


** daily return composites

INTRODUCTION TO FOREIGN EXCHANGE

31

Agenda

I. Size, structure and management of global currency markets

II. Fundamental drivers of exchange rates

11

III. Modelling and forecasting exchange rates

18

IV. Common trading strategies for investors

32

Is trading FX profitable?
 Portfolio construction: the FX Markets Weekly approach
 Common directional, range and relative value trades
 Case study: constructing an FX model portfolio


V. Managing FX hedge ratios for investors and corporates

42

VI. Appendices

62

INTRODUCTION TO FOREIGN EXCHANGE

32

Is trading FX profitable? Yes by several measures


J.P. Morgan
Morgan FX
FX Markets
Markets Weekly
Weekly model
model portfolio
portfolio
J.P.
Success
rates
and
average
return
per
trade
by type
type of
of position.
position.
Success rates and average return per trade by
Average return
return in
in %
% for
for cash
cash and
and directional
directional options
options position,
position, and
and
Average
vol
points
for
options
relative
value.
vol points for options relative value.

Annual
Annual returns
returns by
by currency
currency managers
managers
Rolling
Rolling 12-mo
12-mo returns
returns on
on three
three composites
composites of
of dedicated
dedicated
currency
managers
currency managers
18%
HFR Currency Index

Success rates

Barclay Currency Trader Index

13%

Cash

Options (directional)

Options (RV)

8%
2011

3%
-2%
IV. COMMON TRADING STRATEGIES FOR INVESTORS

2011

50%

-7%
02

04

06

08

10

2011
50%

2010

2010

2010

2009

2009

2009

2008

2008

2008

0%

Performance
Performance of
of J.P.
J.P. Morgan
Morgan model-based
model-based strategies
strategies
Rolling
12-mo
returns
Rolling 12-mo returns

50%

50%

100%

0%

50%

100%

0%

50%

100%

Average return per trade

60%
Options (directonal)

Cash

Options (RV)

40%
2011

2011

2011

2010

2010

2010

G-10 carry

2009

2009

2009

Emerging markets carry

2008

2008

2008

20%
0%
-20%

Rate momentum (forward carry)

-40%
01

03

05

07

0%

09

INTRODUCTION TO FOREIGN EXCHANGE

11

33

1%

2%

3%

-1%

0%

1%

-0.5

0.5

1.0

Portfolio construction: FX Markets Weekly approach vs Markowitz optimization

 Requires thinking like a statistician

Efficient frontier

 requires a view on expected returns and

covariance for every asset/trade, which in


turn increases estimation risk

Expected return

 the alternative relying on historical returns

and vol has a backward-looking bias


 Difficult to translate views into this language

IV. COMMON TRADING STRATEGIES FOR INVESTORS

 garbage in, garbage out


 model results frequently require discretionary

adjustment due to skewed results

Standard deviation

INTRODUCTION TO FOREIGN EXCHANGE

34

A top-down alternative: think in themes, convert to trades

Global themes

Strategy

Trades

(qualitative)

(directional, relative value)

(cash, options)

 Global expansion

 Across asset classes,

overweight risky versus


safe markets.

 Long equities vs bonds


 Long commodity FX vs

USD or JPY
IV. COMMON TRADING STRATEGIES FOR INVESTORS

 Across currencies,

overweight cyclical
versus defensive
currencies
 Sovereign risk

 Underweight bonds,

currencies of countries
with poor fiscal positions

You can get far without point forecasts


INTRODUCTION TO FOREIGN EXCHANGE

35

 Sell 10-yr Italy vs

Germany, sell EUR vs


CHF

The complete process


FX Markets Weekly approach

Markowitz mean-variance optimization

1. Identify independent global macro themes

1. Forecast FX rates for relevant


investment horison

2. Identify trades to express each theme


2. Forecast variance/covariance matrix
Macro (fundamental)
portfolio

IV. COMMON TRADING STRATEGIES FOR INVESTORS

vs

Directional

Cash

Options

Technical portfolio

Relative value

Cash

Directional

Options

Relative value

Cash

3. Optimise for capital allocation to each trade


3. Size trades by conviction

4. Adjust position sizes to control for liquidity risk


4. Set stops technically (levels) and fundamentally (data/policy triggers)

5. Rebalance weekly on Fridays


INTRODUCTION TO FOREIGN EXCHANGE

36

Lower leverage

IV. COMMON TRADING STRATEGIES FOR INVESTORS

Higher leverage

Directional trades: high conviction and large move in spot

Strategy

Example

Rationale/Appropriateness

One-touch

At spot reference 1.05 on USD/CAD, buy a


Best executed when vols are low. Optimal pairs given by assuming a
3-mo one-touch put with 0.96 strike at cost of 10% premium to be paid and filtering for currencies where the distance
18%.
from spot to barrier is smallest in standardised terms (sigmas of recent
realised vol). In this instance, maximum payout is more than 5:1 if
the strike is hit, since payout is 100% of notional for 18% up-front
premium.

At-expiry digital

At spot reference 1.40 on EUR/CHF, buy a


12-mo 1.25 at-expiry digital.

Similar to the one-touch but with more leverage (higher return relative
to premium) since EUR/CHF must be at or below the strike at expiry.

Risk reversal (buy a


call/put and sell a
put/call on same
currency)

At spot reference 8544 on USD/IDR, sell a 1mo risk reversal consisting of buying an 8475
USD/IDR put and selling a 8700 USD/IDR
call.

Useful as protective overlay on cash, particularly on high-yield


currencies. The hedger buys a USD call/Ccy put and sells a USD
put/Ccy call while holding a short USD/Ccy cash FX trade. This trade
floors the downside at the cost of capping the upside. Can be
structured as a zero-cost strategy depending on the strikes. Best
executed when skews are elevated relative to the level of vols.

Sell calls or puts

After G-7 announced co-ordinated


intervention in March 2011, sell USD/JPY
puts struck at 78.

Intervention lows odds of a USD/JPY move below a threshold level, so


selling USD/JPY puts earns premium.

INTRODUCTION TO FOREIGN EXCHANGE

37

Lower leverage

IV. COMMON TRADING STRATEGIES FOR INVESTORS

Higher leverage

Directional trades: lower conviction and modest move in spot


Strategy

Example

Rationale/Appropriateness

Calls (puts) with


reverse knock-outs
(RKOs)

At spot reference 0.92 in USD/CHF, buy a 3mo USD/CHF put struck at 0.90 with RKO at
0.85.

Calls (puts) with


reverse knock-ins
(RKIs)

At spot reference 1.21 on EUR/CHF, buy a 2- Adding an RKI increases the cost relative to the vanilla option but
mo 1.18/1.15 EUR/CHF put with RKI on
provides additional leverage (exposure to EUR/CHF downside) if the
lower strike at 1.11
lower strike is hit prior to expiry.

Call (put) spread

With spot reference 0.9440 on AUD/CHF,


buy a 2-mo 0.91/0.88 out spread for 60bp.

Ratio call (put) spread

At spot reference 1.42 on EUR/USD, buy a 2- Like a vanilla call/put spread, the ratio structure cheapens the
mo 1x2 ratio call spread struck at 1.45 and
position by selling up/downside. Selling twice as much upside
1.50.
achieves greater savings than a 1x1, but is only appropriate if the
buyer has high conviction that the rally will be limited.

Seagull

At spot reference 3.07, buy 1-yr USD/MYR


3.00/2.90 put spread and sell a 1-yr 3.35
USD/MYR call for zero cost

INTRODUCTION TO FOREIGN EXCHANGE

38

Cheapens the vanilla option by selling OTM strike. If the view if too
correct, barrier is hit and option is worthless. Benefits from modest
move in spot. Savings generally arent symmetric between puts and
calls, since high-yield currencies typically are skewed for currency
downside.

AUD/CHF is expected to fall about 5%, resulting in a 2:1 payout ratio


(expected return vs cost). The put spread cheapens the structure by
selling downside beyond the lower strike. Generally target a payout
ratio of 2 or 3 to 1.

Cheapens a vanilla call (put) spread by selling a put (call). Appropriate


when expecting a limited move. Best executed when vols are high
and skews elevated, which maximises the premium savings from
selling an option against the underlying call or put spread.

High leverage

IV. COMMON TRADING STRATEGIES FOR INVESTORS

Low leverage

Range trades
Strategy

Example

Rationale/Appropriateness

Carry trade with cash

Buy basket of four currencies offering


highest risk-adjusted carry (INR, IDR, AUD,
NZD) funded in lowest-yielding currencies
(USD, JPY).

Ideal when vols are high or expected to decline.

Carry trade with options

Buy ATMF ATMS call spread in high-yield


currencies. At spot reference 1.75 on
USD/BRL, buy a 1-mo ATMF (1.7603)
USD/BRL put and sell a 1-mo ATMS
(1.7500) USD/BRL put.

Preferred when vols are high and vol curve steep. Downside on the
trade is floored at the option premium, unlike the cash trade executed
with forwards where the downside is unlimited.

Range binary (double


no-touch)

At a spot reference of 1.42, by a 2-mo


EUR/USD double no-touch with
1.3850/1.4850 barriers.

A method of earning carry in a range-bound market if the spot rate


realises a tighter range than the barriers selected by buying two barrier
options above ad below spot. Similar to a carry trade in that it accrues
gains from the passage of time (theta). Strategy is best executed when
vols are high, and in 1-yr tenors on steep vol curves to achieve a wider
barrier and therefore avoid the gap risk inherent in these structures.

INTRODUCTION TO FOREIGN EXCHANGE

39

Relative value trades

IV. COMMON TRADING STRATEGIES FOR INVESTORS

Strategy

Example

Rationale/Appropriateness

Basket options (worst of)

Buy a basket of 3-mo worst-of USD puts


versus NZD, BRL and TRY

Correlation amongst basket components is low so basket option


achieves a discount relative to the strip of vanillas. If correlation
rises, the worst performer will track best one closely, resulting in a
high payout ratio on the trade.

Correlation swaps

Sell 6-mo USD/CAD vs USD/NZD


correlation via correlation swap

Correlations are bounded between +1 and 1, and are meanreverting. The ideal sell occurs when (1) implied correlation is near
a historic high (low); and (2) realised correlation is below (above)
implied.

INTRODUCTION TO FOREIGN EXCHANGE

40

Case study: constructing a model portfolio


 Investable markets
 All regions
 All currencies
 All instruments (cash, derivatives)
 Inputs to the view

IV. COMMON TRADING STRATEGIES FOR INVESTORS

 Economics/Fundamentals

Global Data Watch (JPM view on cyclical and policy outlook)


Valuation models and position measures for currencies
 Three tasks
 Identify 2 3 global macro themes which should influence currencies over the next three months
 Propose two trades for each theme in cash or options. For options trades, explain why a particular structure

is appropriate for the view.


 Specify stops for the trade in terms of currency levels and fundamental triggers.

INTRODUCTION TO FOREIGN EXCHANGE

41

Agenda

I. Size, structure and management of global currency markets

II. Fundamental drivers of exchange rates

11

III. Modelling and forecasting exchange rates

18

IV. Common trading strategies for investors

32

V. Managing FX hedge ratios for investors and corporates

42







The conventional wisdom on FX exposure: all risk, no reward


Three exceptions: emerging markets, catastrophe insurance, risk diversification
Choosing the optimal hedge ratio: one size never fits all
Using fair value models to focus strategic hedge ratios
Using alpha models to adjust tactical hedge ratios

VI. Appendices

INTRODUCTION TO FOREIGN EXCHANGE

62

42

A decision tree for FX hedge ratios

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Currency
risk

Passive
management

100%
hedged

INTRODUCTION TO FOREIGN EXCHANGE

Active
management

100%
unhedged

43

Asymmetric
hedge

Conventional wisdom on currency exposure: all risk, no return


Equity
Equity market
market returns,
returns, 1988-2009
1988-2009
annual
%,
USD
terms
annual %, USD terms
12%

local ccy

 Conventional wisdom claims that FX exposure

unhedged

delivers more risk than return, since currencies are


mean-reverting over the long run

hedged

9%

 A simple test: compare returns, volatility and riskV. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

6%

adjusted returns in hedged and unhedged terms


inefficiencies

3%

 For USD-based investors, the long-term return

0%

differential from currency exposure has


been modest

-3%
USD

JPY

EUR

GBP

AUD

CAD

MSCI
ex-US

 Unhedged currency exposure has raised equity

and bond returns by about 1.0% per annum on


Euro area, Japanese, Australian and
Canadian assets, but lowered returns on UK
exposure.

Bond
Bond market
market returns,
returns, 1988-2009
1988-2009
annual
%,
USD
terms
annual %, USD terms

12%

local ccy

unhedged

hedged

9%

6%

3%

0%
USD

JPY

EUR

GBP

AUD

INTRODUCTION TO FOREIGN EXCHANGE

CAD

GBI ex
US

44

FX exposure can raise volatility more than returns


Equity
Equity market
market volatility,
volatility, 19882009
19882009
annual
%,
USD
terms
annual %, USD terms
30%

local ccy

unhedged

 Volatility impact can be more significant


 For equities

hedged

 Unhedged Canadian and Australian exposures

have been 7-8 percentage points more volatile

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

20%

 Unhedged UK returns are 3 percentage points


10%

more volatile than local currency returns


 Unhedged Euro area and Japanese equities are

0%
USD

JPY

EUR

GBP

AUD

CAD

similarly volatile, regardless of hedging

MSCI exUS

 For bonds

Bond
Bond market
market volatility,
volatility, 19882009
19882009
annual
%,
USD
terms
annual %, USD terms

 Unhedged bonds are close to twice as volatile as

hedged exposure

15%
local ccy

unhedged

hedged

12%
9%
6%
3%
0%
USD

JPY

EUR

GBP

AUD

INTRODUCTION TO FOREIGN EXCHANGE

CAD

GBI ex
US

45

Exception 1: With emerging markets FX exposure, strategic hedging does not pay
EM
EM FX
FX returns:
returns: spot
spot versus
versus carry,
carry, 1994-2009
1994-2009
based
on
returns
from
J.P.
Morgan
ELMI+
based on returns from J.P. Morgan ELMI+ index
index

 Unlike G-10 FX which tends to mean-revert,

emerging market currencies tend to trend.

20%

 Spot appreciation stems from (1) higher return on

15%
10%
13%

5%

13%

17%
10%

15%

-10%

-9%

-10%

-7%

6%

7%

6%

-10% -11%

-6%

4%
-3%

6%

9%

2%

1%

5%
2%

3%

-12%

-24%

-15%

return from FX appreciation/depreciation

-20%

return from carry

capital in stronger-growth, higher interest rate


economies; (2) current account surpluses in
commodity exporters.
 Carry is on average positive and about twice the

level of G-10 rate differentials.

-25%
-30%
94

96

98

00

02

04

06

 For G-10 based corporates and investors, strategic

08

hedging results in losses over the long term.


Emerging
Emerging markets
markets FX
FX Sharpe
Sharpe ratios,
ratios, 1994-2009
1994-2009
based
on
returns
from
J.P.
Morgan
ELMI+
based on returns from J.P. Morgan ELMI+ index
index
0.7
0.61

0.5

0.42

Europe

-0.02
Asia

-0.1

0.14

ME/Africa

0.1

0.12

Latam

0.3

ELMI+

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

-5%

-5%

8%

14%
4%

0%

7%

INTRODUCTION TO FOREIGN EXCHANGE

46

Exception 2: Risk insurance and Asset/Liability matching


Currency
Currency composition
composition of
of central
central bank
bank reserves,
reserves, 2011
2011
As
As percentage
percentage of
of global
global total
total

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

4%

 Domestic event risks can justify unhedged

foreign exposure
 Japanese insurance companies have

5%

4%

USD holdings (earthquake insurance)


 Investors from emerging markets hold

unhedged foreign assets


27%
60%

USD

EUR

GBP

JPY

INTRODUCTION TO FOREIGN EXCHANGE

Other

47

 Central banks match foreign liabilities with

foreign assets

Exception 3: Risk diversification from FX

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Domestic asset
risk

Covar domestic, foreign

 Portfolio a function of

Foreign asset
risk
2foreign

2domestic

 domestic assets
 foreign assets
 currencys
 covariance between domestic and

Covar domestic, fx

Covar foreign, fx

foreign assets
 covariance between

domestic/foreign assets and


currency

Currency risk
2fx

INTRODUCTION TO FOREIGN EXCHANGE

48

Conditions for lowering portfolio volatility through FX exposure

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

2unhedged < 2hedged when


w2foreign 2fx + 2 wforeign (wdomesticdomestic, fx + wforeign foreign, fx ) < 0
Foreign

FX

exposure

vol

Domestic asset covar


with FX

Foreign asset
covar with FX

 Positive correlation between FX and assets increases

portfolio vol
 Negative correlation can reduce portfolio vol, if

sufficiently large
 Covariance between assets and FX must be large and

negative

INTRODUCTION TO FOREIGN EXCHANGE

49

An example of required breakeven correlations


Breakeven
Breakeven correlations
correlations

 How negative must the correlation be to

reduce portfolio volatility?

0.00

 For simplicity, assume

breakeven FX/equity correlation

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

-0.10

FX/asset vol ratio = 0.50

 US and foreign equity markets are


-0.20

equally volatile
FX/asset vol ratio = 1.0

-0.30

 US and foreign equities are equally

correlated with FX

-0.40

 Input various vols for assets and FX, and

-0.50

solve for breakeven correlation which


reduces portfolio volatility

FX/asset vol ratio = 1.25


-0.60

 If FX is half as volatile as assets and

-0.70

foreign allocation is 50% of portfolio,


FX/asset correlation must be at least 0.12

-0.80

10%

30%

50%

70%

90%

% allocation to foreign equities

 If FX is as volatile as assets, correlation

must be at least -0.25

INTRODUCTION TO FOREIGN EXCHANGE

50

US investors perspective: Equity/bond and FX correlations insufficiently negative


Correlation* of foreign stocks and FX, 1990-2009
monthly returns, 3 year rolling periods, USD terms
0.4
EUR
0.2

GBP

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

0.0
-0.2
-0.4
-0.6
-0.8
90

93

96

99

02

05

08

Correlation* of foreign bonds and FX, 1990-2009


0.8
CAD

AUD

JPY

0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
90

93

96

99

02

05

08

*negative correlation indicates that ccy depreciates vs USD when equities or bonds rally
INTRODUCTION TO FOREIGN EXCHANGE

51

Choosing the optimal hedge ratios: one size never fits all

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Covar domestic, foreign

 The optimal hedge ratio is percentage of foreign

Domestic asset
risk

Foreign asset
risk

currency exposure which should be hedged to

2domestic

2foreign

 raise the portfolios risk-adjusted returns (Sharpe

ratio); or
 minimise the portfolios volatility ().

Covar domestic, fx

Covar foreign, fx

 Given the number of variables affecting

portfolio vol, optimal hedge ratio depends on

Currency
risk

 allocation between domestic and international

assets

2fx

 the currency allocation of foreign assets


 consistency of historical volatilities and

correlations in the future


 investors risk preference
 Optimal hedge ratio therefore will vary by

investor and over time.

INTRODUCTION TO FOREIGN EXCHANGE

52

Example: US investor with 70% US, 30% non-US exposure


Current
Current portfolio
portfolio allocation,
allocation, %
%

UK equities Canadian Australian


equities
5%
equities
1%
2%

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Euro area
equities
8%

Portfolio performance,
performance, 1987
1987 -- 2010
2010
Portfolio

Swiss
equities
2%

US equities
US gov't bonds
US real estate
EM equities
World equities ex-US
Global gov't bonds ex US
Japanese equities
Euro area equities
UK equities
Canadian equities
Australian equities
Swiss equities

US equities
18%

Japanese
equities
4%
US real
estate
7%

US gov't
bonds
47%

World
equities ex-US
6%

Unhedged portfolio

Returns

Vol

IR

Client allocation

9.9%

14.9%

0.66

18.3%

7.1%

4.7%

1.51

47.0%

10.1%

18.1%

0.56

6.7%

3.4%

18.3%

0.18

0.0%

6.6%

17.3%

0.38

5.6%

6.7%

9.1%

0.74

0.0%

0.8%

22.1%

0.04

4.1%

8.5%

23.0%

0.37

8.2%

5.7%

14.9%

0.39

4.8%

9.2%

19.6%

0.47

2.3%

8.3%

20.7%

0.40

1.1%

10.1%

17.4%

0.58

1.9%

7.7%

7.9%

0.98

 Portfolio of 70% US assets/30% foreign assets has returned 7.7% annually since 1987 with

annualised vol of 7.9%, for risk-adjusted returns (information ratio) of 0.98.


 Note: EM assets categorised as World equities ex-US given smaller data history on

EM hedged indices (only since 1999)

INTRODUCTION TO FOREIGN EXCHANGE

53

Optimisation results
Optimal
Optimal hedge
hedge ratios
ratios to
to maximise
maximise IR
IR or
or minimise
minimise volatility
volatility

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Criterion: maximise IR
World equities ex-US
Japanese equities
Euro area equities
UK equities
Canadian equities
Australian equities
Swiss equities

 Optimisation process

Criterion: minimise vol

0%

100%

100%

50%

100%

100%

0%

50%

100%

100%

100%

100%

75%

0%

investor. Only the FX hedge ratio can vary, to be either


0%, 25 %, 50%, 75% or 100%.
 Optimiser solves for the combination of hedge ratios which

(1) maximises the portfolios risk-adjusted returns


(information ratio) or (2) minimises the portfolios volatility.
 Results
 To maximise IR: hedge equities in Japan, Euro area,

Canada and Australia 100%; hedged Swiss equities 75%.


Leave all other non-US asset unhedged.

Performance
Performance statistics
statistics for
for hedged
hedged and
and unhedged
unhedged portfolios
portfolios

Annual returns Annual vol


Unhedged portfolio
Maximum IR portfolio
Minimum volatility portfolio

 Percentage allocation to non-US assets is fixed by the

IR

7.7%

7.9%

0.98

7.6%

7.5%

1.02

7.4%

7.5%

1.00

 IR improves slightly from 0.98 to 1.02 due to modest

decline in vol (from 7.9% to 7.5%).


 Small improvement in IR due to (1) size of international

exposure; (2) small negative correlation between stocks


and FX and (3) comparable vol between hedged and
unhedged equities
 To minimise vol: hedge equities in Euro area, Canada

and Australia 100%. Hedge UK and Japan 50%.


 Caveats
 Results assume historical returns, correlations and

volatilities are stable going forward.

INTRODUCTION TO FOREIGN EXCHANGE

54

An additional wrinkle: cash flow consequences of fully hedged portfolios


Japanese
Japanese equities:
equities: volatility
volatility of
of hedged
hedged vs
vs
unhedged
returns,
19882009
unhedged returns, 19882009
12mo-mo
12mo-mo rolling
rolling vol,
vol, USD
USD as
as base
base currency
currency

US
US equities:
equities: hedged
hedged and
and un-hedged
un-hedged into
into GBP
GBP
volatility
volatility of
of hedged
hedged vs
vs unhedged
unhedged returns,
returns, 19882010
19882010
35%

50%
unhedged

25%

30%
V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Hedged

30%

hedged

40%

Unhedged

20%
15%

20%

10%

10%

5%

0%

0%

89

92

95

98

01

04

07

10

88

90

92

94

96

98

00

02

04

06

 During the credit crisis, unhedged equity market returns became more volatile than hedged

ones in cases where the foreign investor was short a currency which was strengthening.
 US investors in the Nikkei were short JPY as it strengthened.
 European and Australian investors in US equities were short USD as it strengthened.
 Cash flows implications were significant, sometimes obliging investors to liquidate underlying

assets to generate sufficient funds to rebalance FX hedges.

INTRODUCTION TO FOREIGN EXCHANGE

55

08

Symmetric vs asymmetric benchmarks: 50% hedging is option of least regret


Performance
Performance with
with and
and without
without overlay
overlay

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Pass-through to investor (%)


12

 Asymmetric/polar benchmarks
 100% hedged or unhedged
 allows manager to profit in only one

symmetric hedge + overlay

environment
 Symmetric benchmarks

 50% hedged/unhedged (or some variant)

 allows manager to profit regardless of

currencys direction

 similar to call option

-4
unhedged
-8
-12
-12

-8

-4

12

Currency return (%)

INTRODUCTION TO FOREIGN EXCHANGE

56

Using long-term fair value models to focus strategic hedge ratios


G10
G10 real
real trade-weighted
trade-weighted FX
FX deviations
deviations from
from long-term
long-term fair
fair
value
(%),
2010
Q1

2011
Q1
value (%), 2010 Q1 2011 Q1
16
12

1Q10

3Q10

 Model: real effective exchange rate modelled as

function of terms of trade (+ impact), current account


balance (-), international investment income balance
(+), government debt (-) and inflation (-).

1Q11

8
4

 Hedging rule: sell (buy) currencies which are over

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

(under) valued by at least 10%. Hold hedge for 6 to


12-months to capture mean reversion.

-4
-8
-12

 Current signals

-16

 In real effective (trade-weighted terms), the

NOK GBP USD CAD SEK NZD AUD EUR CHF JPY

cheapest currencies are NOK, GBP, and USD,


and the most expensive are JPY, CHF, and EUR.

G-10
G-10 exchange
exchange rate
rate deviations
deviations from
from 2011
2011 Q1
Q1 fair
fair value
value (%)
(%)
Misalignments
measured
as
average
spot
rate
Jun
24-30
vs
Misalignments measured as average spot rate Jun 24-30 vs Q1
Q1
fair
fair value
value estimate.
estimate. A
A negative
negative (positive)
(positive) value
value indicates
indicates under
under
(over)
(over) valuation
valuation of
of the
the foreign
foreign currency
currency vs
vs USD
USD or
or EUR.
EUR.

 In bilateral terms, the currencies breaching 10%

30

misalignment are:

v s USD
20

 USD-based hedgers: CHF, JPY, NZD, EUR,

v s EUR

and AUD are too expensive vs USD, so are


sells.

10
0

 EUR-based hedgers: NOK, GBP, CAD, USD,

-10

and SEK are cheap vs EUR, so are buys; CHF


is expensive vs EUR so is a sell.

-20
NOK

GBP

CAD

SEK

AUD

EUR

NZD

INTRODUCTION TO FOREIGN EXCHANGE

JPY

CHF
57

Using alpha models to adjust tactical hedge ratios


Current
Current signals
signals from
from rate
rate momentum
momentum model
model (forward
(forward carry)
carry)
Signals
based
on
changes
in
1-month
rates
3-months
forward
Signals based on changes in 1-month rates 3-months forward over
over the
the past
past month
month
USD

JPY

EUR

GBP

CHF

NOK

SEK

CAD

AUD

NZD

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

USD-based hedgers
Current signal (column ccy vs.USD)

NA

Sell

Buy

Sell

Sell

Buy

Buy

Sell

Sell

Sell

Change in spreads over past month (bp, column ccy minus US)

NA

-4.0

11.4

-3.0

-6.3

14.1

2.9

-3.1

-28.0

-4.9

Signal returns over past 6mos

NA

3.0%

0.7%

1.7%

-1.5%

12.0%

3.2%

4.8%

-13.4%

1.5%

Current signal (column ccy vs.EUR)

Sell

Sell

NA

Sell

Sell

Buy

Sell

Sell

Sell

Sell

Change in spreads over past month (bp, column ccy minus Euro)

-11.4

-15.4

NA

-14.4

-17.7

2.7

-8.5

-14.5

-39.4

-16.3

Signal returns over past 6mos

0.7%

2.3%

NA

0.8%

-10.6%

-4.0%

-3.8%

5.6%

3.7%

-5.2%

EUR-based hedgers

GBP-based hedgers
Current signal (column ccy vs.GBP)

Buy

Sell

Buy

NA

Sell

Buy

Buy

Sell

Sell

Sell

Change in spreads over past month (bp, column ccy minus UK)

3.0

-1.0

14.4

NA

-3.3

17.0

5.9

-0.2

-25.0

-1.9

1.7%

8.4%

0.8%

NA

-1.8%

-5.8%

-1.2%

-2.2%

-7.8%

4.3%

Signal returns over past 6mos

 Model
 Rate expectations drive short-term currency trends by signalling shifts in cyclical momentum, relative monetary

policy and eventually carry. Thus we use the term forward carry to describe a signal based on changes in rate
expectations between two countries.
 Hedging rule is to sell (buy) currencies in whose favor interest rate expectations have moved over past month.
 Current signals
 USD-based hedgers: Buy USD vs JPY, GBP, CHF, CAD, AUD and NZD and sell USD vs all other currencies.
 EUR-based hedgers: Buy EUR vs USD, JPY, GBP, CHF, SEK, CAD, AUD, NZD and sell EUR vs. NOK.
INTRODUCTION TO FOREIGN EXCHANGE

58

Corporate hedging policy: six key issues


Percentage
Percentage of
of year-ahead
year-ahead revenues
revenues that
that G-3
G-3 corporates
corporates
hedged
by
Q1
and
Q3
of
each
year
hedged by Q1 and Q3 of each year
Based
Based on
on J.P.
J.P. Morgan
Morgan Corporate
Corporate Hedging
Hedging Survey
Survey conducted
conducted each
each
quarter
quarter

 1. Coverage: Balance sheet versus cash flow hedging


 Most corporates would not hedge balance sheet

exposure if they plan to be invested in the country for a


very long time. The cost could also be substantial given
the size of foreign exposure. Private equity firms are
most likely to hedge the investment since they intend to
dispose within a few years. Corporates tend to hedge
cash flows only, on a rolling basis.

4 0%

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

as of Q 1

as of Q 3

3 0%

2 0%

 2. Hedge ratio: Full versus partial hedging


1 0%

 Optimal hedge ratios are not uniform across

corporates. Depends on predictability of cash flows,


tightness of margins, natural currency diversification
of the firms business and treasurys ability to forecast
exchange rates. In J.P.Morgans quarterly Corporate
Hedging Survey, corporates on average hedge 75% of
quarter-ahead cash flows and 25% of year-ahead cash
flows.

0%
20 06

2 00 7

2 00 8

20 09

20 10

20 11

 3. Management: Centralised versus local


 Centralised hedging takes portfolio approach to the firms

exposure, so benefits from netting. In many EM


currencies (Asia), however, exchange controls could
require the local subsidiary to hedge onshore. Most
corporates centralise hedging unless exchange controls
are prohibitive.
INTRODUCTION TO FOREIGN EXCHANGE

59

Corporate hedging policy: forwards versus options


Option-based
Option-based hedges
hedges (ATM
(ATM puts
puts or
or risk
risk reversals)
reversals) have
have
outperformed
forwards
outperformed forwards
Benchmark
Benchmark hedge
hedge is
is a
a 50%
50% short
short foreign
foreign currency
currency forward.
forward. Option
Option
hedges
are
sized
to
provide
the
same
hedge
ratio
as
hedges are sized to provide the same hedge ratio as the
the
benchmark
benchmark forward
forward hedge
hedge at
at inception.
inception. No
No transaction
transaction costs
costs
Local
V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Currency

AUD

EUR

GBP

Strategy

Average
Return

Volatility

 Forwards are considered simpler, less-risky

instruments because they guarantee a conversion rate


for future cash flows. Still, many corporates are
reluctant to hedge when foreign rates are above
domestic ones, thus entailing a negative carry hedge.

IR

Unhedged

-6.5%

15.2%

-0.43

Hedged v ia Forw ard

-1.8%

6.3%

-0.28

Hedged v ia Option

0.1%

7.8%

0.01

Hedged v ia 40dRiskRev ersal

-1.5%

5.9%

-0.26

Hedged v ia 25dRiskRev ersal

-1.7%

5.8%

-0.29

Hedged v ia 10dRiskRev ersal

-6.4%

13.4%

-0.48

Hedged v ia Signal (option and fw d)

-0.6%

8.2%

-0.08

Hedged v ia Signal (25d rr and fw d)

-1.8%

5.9%

-0.30

Unhedged

-3.1%

10.1%

-0.31

Hedged v ia Forw ard

-1.6%

4.6%

-0.35

Hedged v ia Option

-1.5%

5.5%

-0.28

Hedged v ia 40dRiskRev ersal

-1.4%

4.6%

-0.30

Hedged v ia 25dRiskRev ersal

-1.2%

4.8%

-0.24

Hedged v ia 10dRiskRev ersal

-2.6%

6.7%

-0.38

Hedged v ia Signal (option and fw d)

-1.5%

5.6%

-0.28

Hedged v ia Signal (25d rr and fw d)

-1.6%

4.8%

-0.33

Unhedged

0.7%

10.5%

0.07

Hedged v ia Forw ard

0.9%

5.0%

0.18

Hedged v ia Option

1.0%

6.2%

0.15

Hedged v ia 40dRiskRev ersal

1.0%

5.1%

0.19

Hedged v ia 25dRiskRev ersal

1.0%

5.6%

0.18

Hedged v ia 10dRiskRev ersal

0.5%

8.6%

0.06

Hedged v ia Signal (option and fw d)

0.8%

5.9%

0.13

Hedged v ia Signal (25d rr and fw d)

1.1%

5.5%

0.19

INTRODUCTION TO FOREIGN EXCHANGE

 4. Instruments: Forwards versus options

 The conventional wisdom on forwards understates

their limitations. Options such as vanilla currency puts


have the advantage of entailing a defined downside
(premium paid) and can be structured as zero-cost
instruments (risk reversals/collars).
 5. Timing: Fixed hedging schedule versus

opportunistic hedging
 Fixed hedging every month, quarter or year should be

done when the objective is to minimise cash flow


volatility and the corporate has no view on currency
direction. Opportunistic hedging is more cost-effective
when the corporate has some success in identifying
the currencies most vulnerable to a large move. The
treasurer could control for forecast error by hedging
less than 100%.

60

Proxy hedging: sensible under certain conditions

V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES

Beta
Beta matrix:
matrix: EM
EM Asian
Asian currencies
currencies
Beta
Beta from
from regressing
regressing row
row currency
currency on
on column
column currency
currency over
over past
past 12mos;
12mos;
based
on
weekly
changes
based on weekly changes

SGD
MYR
THB
TWD
KRW
INR
IDR
PHP
CNY
HKD

SGD
MYR
THB
TWD KRW
INR
IDR
PHP
CNY
HKD
NA
0.53
0.58
0.64
0.29
0.61
0.79
0.55
1.22
4.00
0.81 NA
0.29
0.86
0.42
0.70
1.33
0.75
1.23
4.17
0.30
0.10 NA
0.24
0.07
0.24
0.12
0.19
0.57
1.07
0.48
0.42
0.35 NA
0.25
0.47
0.53
0.38
1.10
3.08
1.70
1.61
0.80
2.00 NA
1.56
2.43
1.56
1.82 11.48
1.02
0.76
0.76
1.04
0.44 NA
1.29
0.78
1.69
5.41
0.44
0.49
0.12
0.40
0.23
0.43 NA
0.43
0.47
2.55
0.99
0.89
0.65
0.93
0.48
0.85
1.40 NA
0.82
5.27
0.11
0.08
0.10
0.14
0.03
0.09
0.08
0.04 NA
0.24
0.09
0.06
0.04
0.09
0.04
0.07
0.10
0.06
0.06 NA

 6. Proxy hedging: depends on four

variables
 Beta between underlying exposure

(asset/earnings stream) and proxy variable


 Liquidity of underlying versus proxy
 Cost of underlying versus proxy
 Size of underlying exposure relative to

total portfolio/corporate exposure


 Proxy hedging is sensible where the

exposure is meaningful, the beta high, the


liquidity deeper elsewhere and the cost
cheaper
 Example
 TWD exposure well hedged with CNY but

not with MYR or KRW


 KRW exposure not well hedged with other

currencies, thus highlighting the


idiosyncratic risk

INTRODUCTION TO FOREIGN EXCHANGE

61

Agenda

I. Size, structure and management of global currency markets

II. Fundamental drivers of exchange rates

11

III. Modelling and forecasting exchange rates

18

IV. Common trading strategies for investors

32

V. Managing FX hedge ratios for investors and corporates

42

VI. Appendices

62

J.P. Morgan currency and volatility indices


 Data tables: global FX turnover in spot and options, global central bank reserves
 Currency timelines since 1970
 J.P. Morgan Global FX Strategy


INTRODUCTION TO FOREIGN EXCHANGE

62

J.P. Morgan nominal effective exchange rate indices


J.P.
J.P. Morgan
Morgan US
US Dollar
Dollar TCI
TCI weights
weights
Based
on
2000
trade
weights
Based on 2000 trade weights

 Tradeable Currency Indices (TCIs) are investable

versions of nominal trade-weighted indices produced


by J.P. Morgan Economic Research since the 1970s

TWD, 4.5%
KRW, 4.8%

EUR, 19.8%

 TCIs currently are available for 17 countries in the G-

GBP, 4.9%

10 and emerging markets. Intra-day indications and


daily fixings are posted on Bloomberg <ALLX JPMQ>

CNY, 10.0%

CAD, 19.2%

 TCIs offer three advantages over existing products:


MXN, 13.4%

more representative weights, a mechanism for regular


reweighting and broader country coverage

JPY, 16.4%

 TCIs can be used for several medium-term investment

DXY
DXY weights
weights
CHF 3.6%

strategies such as macro hedges, lower-volatility carry


trades and cheaper long-term valuation trades

SEK 4.2%
CAD 9.1%

 J.P. Morgan offers forwards and options on

the indices

GBP 11.9%

 See J.P. Morgan Tradeable Currency Indices (TCIs),

EUR 57.6%

J. Normand, Jul 2, 2007

VI. APPENDICES

JPY 13.6%

INTRODUCTION TO FOREIGN EXCHANGE

63

J.P. Morgan real effective exchange rate indices


J.P.
J.P. Morgan
Morgan REER
REER for
for USD,
USD, EUR
EUR and
and JPY
JPY
Index
value
Index value

 J.P. Morgan has been publishing real effective

exchange rate indices since the early 1970s.

150
USD

140

EUR

JPY

 Monthly levels on real trade-weighted indices

130

constructed by J.P.Morgan and covering 45


countries. Data are available since the 1970s
for G-10 countries, and since the 1980s for
most other markets.

120
110
100
90
80

 Available on Bloomberg with tickers JBXR

70

plus the currency code (e.g. JBXRUSD for the


dollars real effective exchange rate).

60
70

75

80

85

90

95

00

05

10

 See J.P. Morgan effective exchange rates:

revised and modernized, D. Hargreaves and C


Strong, May 30, 2003

VI. APPENDICES

J.P.
J.P. Morgan
Morgan real
real effective
effective exchange
exchange rate
rate indices
indices on
on
www.morganmarkets.com/GlobalFXStrategy
www.morganmarkets.com/GlobalFXStrategy

INTRODUCTION TO FOREIGN EXCHANGE

64

J.P. Morgan VXY Global TM index of global FX implied volatility


TM
J.P.
J.P. Morgan
Morgan VXY
VXY Global
GlobalTM weights,
weights, 2010
2010
Based
on
BIS-reported
options
Based on BIS-reported options market
market turnover
turnover

INR, 1.9%
BRL, 2.0%

 In 2006 J.P. Morgan launched VXY and EM-

VXY as the first benchmarks for aggregate FX


implied volatility for G-10 and emerging
markets.

+ 6.3% for TRY, NOK, SGD,


PLN, ZAR, TWD, HUF, RUB,
PHP & SEK

CNY, 1.7%

MXN, 2.1%
NZD, 2.1%

 VXY Global was launched in 2011 to produce

KRW, 2.1%

the worlds first global index for currency vol.

CHF, 3.4%

EUR, 30.2%

 The indices are based on 3-month at-the-

CAD, 4.4%

money-forward options weighted by market


turnover

AUD, 6.2%
GBP, 9.5%

 VXY is priced continuously and intra-day

JPY, 26.5%

J.P.
J.P. Morgan
Morgan VXY
VXY

TM
Global
GlobalTM

updates are reported on Bloomberg through


the tickers JPMVXYGL <Index>

level
level (%)
(%)

30%
LTCM

25%

 See Rebalancing VXYTM and Introducing VXY

Lehman

GlobalTM, J Normand and A. Sandilya,


March 25, 2011.

Japan/
MENA

ERM
Mexico

20%

VI. APPENDICES

15%
Greece

10%
5%
92

95

98

01

04

INTRODUCTION TO FOREIGN EXCHANGE

07

10
65

J.P. Morgan VXYTM index of G-10 FX implied volatility


TM
J.P.
J.P. Morgan
Morgan VXY
VXYTM weights,
weights, 2010
2010
Based
on
BIS-reported
Based on BIS-reported options
options market
market turnover
turnover

AUD, 7.4%
CHF, 4.1%

CAD, 5.2%

 In 2006 J.P. Morgan launched VXY and EM-

VXY as the first benchmarks for aggregate FX


implied volatility

NZD, 2.5%

 The indices are based on 3-month at-the-money-

JPY, 31.8%

forward options weighted by market turnover

NOK, 0.9%

 VXY and EM-VXY can be used to measure

SEK, 0.3%

aggregate risk premia in currency markets,


calibrate trading strategies and express views on
volatility as an asset class

GBP, 11.4%

EUR, 36.3%

 VXY is priced continuously and intra-day

updates are reported on Bloomberg through the


tickers JPMVXYG7 <Index>
 J.P. Morgan offers access through forward

contracts that will settle with reference to a


fixing level

VI. APPENDICES

 See Introducing the J.P. Morgan VXY & EM-

VXY, J. Normand and A. Sandilya,


Dec 11, 2006.

INTRODUCTION TO FOREIGN EXCHANGE

66

J.P. Morgan EM-VXYTM index of emerging markets FX implied volatility


TM
J.P.
J.P. Morgan
Morgan EM-VXY
EM-VXYTM weights,
weights, 2010
2010
Based
on
BIS-reported
options
market
Based on BIS-reported options market turnover
turnover

ZAR, 4.8%
TRY, 10.0%

 EM-VXY is the first benchmark for implied

volatility in emerging markets currencies


 The indices are based on 3-month at-the-

BRL, 13.5%

money-forward options weighted by market


turnover

RUB, 2.4%
HUF, 1.6%
PLN, 3.2%

 EM-VXY is priced continuously and intra-day

MXN, 13.9%

PHP, 1.6%

updates are reported on Bloomberg through


the ticker JPMVXYEM <Index>

INR, 12.4%

 J.P. Morgan offers access to the index through

CNY, 11.2%
SGD, 7.8%

forward contracts that will settle with reference


to a fixing level

TWD, 3.4%
KRW, 14.1%

 See Introducing the J.P. Morgan VXY & EM-

VI. APPENDICES

VXY, J. Normand and A. Sandilya,


Dec 11, 2006

INTRODUCTION TO FOREIGN EXCHANGE

67

Appendix table 1: Global FX turnover, 2001-10: spot markets


Global
Global FX
FX turnover
turnover in
in spot
spot markets,
markets, 2001
2001 to
to 2010
2010
All
figures
in
$
billion,
based
on
BIS
Triennial
Central
All figures in $ billion, based on BIS Triennial Central Bank
Bank Survey
Survey
2010

VI. APPENDICES

vs all
currencies

2007

vs USD

vs all
currencies

vs EUR

2004

vs USD

vs all
currencies

vs EUR

2001

vs USD

vs all
currencies

vs EUR

vs USD

vs EUR

USD

1187

NA

469

790

NA

265

528

NA

195

327

NA

116

JPY

300

183

73

206

140

44

130

104

24

101

81

18

EUR

691

469

NA

420

265

NA

273

195

NA

166

116

NA

GBP

212

139

50

150

103

30

83

61

18

42

28

12

SEK

19

11

18

10

10

NA

NA

NA

NA

NOK

12

NA

NA

12

NA

NA

NA

NA

NA

NA

DKK

NA

NA

NA

NA

NA

NA

NA

NA

CHF

92

51

35

88

49

33

41

22

17

27

18

AUD

111

84

53

39

29

25

0.9

14

13

0.5

CAD

78

65

38

33

24

23

0.7

16

15

0.3

NZD

22

NA

NA

17

NA

NA

NA

NA

NA

NA

BRL

NA

NA

NA

NA

NA

NA

NA

MXN

18

NA

NA

15

NA

NA

11

NA

NA

NA

NA

CNY

NA

NA

NA

0.9

NA

NA

0.04

NA

NA

HKD

19

13

NA

16

NA

NA

NA

NA

NA

NA

TWD

NA

NA

NA

NA

NA

NA

NA

NA

KRW

21

20

NA

15

NA

NA

11

NA

NA

NA

NA

SGD

16

NA

NA

NA

NA

NA

NA

NA

NA

THB

NA

NA

1.2

NA

NA

1.3

NA

NA

0.5

NA

NA

IDR

NA

NA

1.4

NA

NA

0.8

NA

NA

0.3

NA

NA

INR

14

13

NA

NA

NA

NA

NA

NA

NA

PHP

NA

NA

1.3

NA

NA

NA

NA

NA

NA

CZK

1.3

NA

NA

NA

NA

0.7

NA

NA

0.7

NA

NA

PLN

NA

NA

NA

NA

NA

NA

NA

NA

HUF

NA

NA

NA

NA

0.8

NA

NA

0.2

NA

NA

RUB

18

NA

NA

18

NA

NA

10

NA

NA

NA

NA

TRY

NA

NA

NA

NA

0.8

NA

NA

0.3

NA

NA

ZAR

NA

NA

NA

NA

NA

NA

NA

Source: J.P. Morgan and BIS Triennial Central Bank Survey

INTRODUCTION TO FOREIGN EXCHANGE

68

Appendix table 2: Global FX turnover, 2001-10: options markets


Global
Global FX
FX turnover
turnover in
in options
options markets,
markets, 2001
2001 to
to 2010
2010
All
All figures
figures in
in $
$ billion,
billion, based
based on
on BIS
BIS Triennial
Triennial Central
Central Bank
Bank Survey
Survey
2010

VI. APPENDICES

vs all
currencies

2007

vs USD

vs all
currencies

vs EUR

2004

vs USD

vs all
currencies

vs EUR

2001

vs USD

vs all
currencies

vs EUR

vs USD

vs EUR

USD

160

NA

51

158

43

43

92

NA

31

48

NA

JPY

54

44

60

38

16

37

27

10

24

17

EUR

87

51

NA

81

43

NA

51

31

NA

26

16

NA

GBP

20

10

28

19

12

SEK

2.95

0.28

0.4

1.65

NA

NA

0.680

NA

NA

NOK

1.90

NA

NA

NA

NA

0.86

NA

NA

0.318

NA

NA

DKK

0.20

NA

NA

0.18

NA

NA

0.26

NA

NA

0.059

NA

NA

CHF

13.40

16

2.903

AUD

15.33

10

13

0.71

0.7

3.421

0.1

CAD

6.10

10

0.35

0.2

2.978

0.007

NZD

2.79

NA

NA

3.81

NA

NA

0.81

NA

NA

0.054

NA

NA

BRL

4.66

NA

1.68

NA

NA

0.42

NA

NA

0.250

NA

NA

MXN

2.32

NA

NA

4.19

NA

NA

0.71

NA

NA

0.135

NA

NA

CNY

5.00

NA

0.24

NA

NA

0.14

NA

NA

0.001

NA

NA

HKD

1.69

NA

3.86

NA

NA

0.37

NA

NA

0.075

NA

NA

TWD

1.27

NA

NA

0.34

NA

NA

0.72

NA

NA

0.144

NA

NA

KRW

3.56

NA

3.08

NA

NA

0.58

NA

NA

0.159

NA

NA

SGD

2.68

NA

NA

0.99

NA

NA

0.27

NA

NA

0.161

NA

NA

THB

0.10

NA

NA

0.06

NA

NA

0.13

NA

NA

0.004

NA

NA

IDR

0.16

NA

NA

0.23

NA

NA

0.01

NA

NA

0.000

NA

NA

INR

3.75

NA

2.08

NA

NA

0.10

NA

NA

0.000

NA

NA

PHP

0.69

NA

NA

0.04

NA

NA

0.01

NA

NA

0.001

NA

NA

CZK

0.22

NA

NA

0.23

NA

NA

0.10

NA

NA

0.058

NA

NA

PLN

2.08

NA

NA

0.94

NA

NA

0.26

NA

NA

0.103

NA

NA

HUF

1.24

NA

NA

0.27

NA

NA

0.07

NA

NA

0.002

NA

NA

RUB

1.05

NA

NA

0.09

NA

NA

0.01

NA

NA

0.001

NA

NA

TRY

3.76

NA

NA

0.91

NA

NA

0.05

NA

NA

0.001

NA

NA

ZAR

1.04

NA

1.23

NA

NA

0.28

NA

NA

0.317

NA

NA

Source: J.P. Morgan and BIS Triennial Central Bank Survey

INTRODUCTION TO FOREIGN EXCHANGE

69

16

Appendix table 3: Global central bank FX reserves

VI. APPENDICES

Central
Central bank
bank FX
FX reserves,
reserves, 2000
2000 to
to 2011
2011
All
figures
in
$
billion
All figures in $ billion
2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

China

3045

2847

2399

1946

1528

1066

819

610

403

286

212

166

Japan

1062

1036

997

1003

948

875

829

824

653

451

388

347

Russia

524

479

438

438

454

281

165

114

65

44

33

24

Saudi Arabia

482

443

397

440

304

224

153

23

18

17

15

18

Taiwan

399

382

348

292

270

266

253

242

207

162

122

107

Norway

305

307

282

357

330

354

318

268

251

225

211

246

Brazil

330

289

239

194

180

86

54

53

49

38

36

33

Korea

304

292

270

201

262

239

210

199

155

121

103

96

India

277

268

259

246

267

170

131

125

97

67

45

37

Hong Kong

273

269

256

183

153

133

124

124

118

112

111

108

Singapore

240

226

188

174

163

136

116

113

96

82

76

80

Switzerland

230

217

92

44

44

37

35

54

46

38

30

31

Euro area

214

207

194

202

203

184

167

181

188

216

208

219

Thailand

184

172

138

111

87

67

52

50

42

39

33

33

Algeria

174

157

147

143

110

78

56

43

33

23

18

12

Mexico

130

114

91

85

78

68

69

61

56

46

40

34

Malaysia

133

106

97

91

101

82

70

67

45

35

31

30

Libya

101

99

96

91

78

58

38

24

18

13

14

11

Indonesia

118

96

66

52

57

43

35

36

36

32

28

29

Poland

93

81

70

57

55

45

39

35

32

27

24

25

Turkey

93

81

70

70

71

61

51

36

34

27

19

20

Denmark

89

77

76

40

33

30

33

40

38

27

17

15

Israel

77

71

61

42

28

29

28

27

26

24

23

23

Philippies

69

62

44

37

34

23

18

17

17

16

16

15

Source: J.P. Morgan and national central banks/finance ministries

INTRODUCTION TO FOREIGN EXCHANGE

70

Appendix table 3: Global central bank FX reserves


Central
Central bank
bank FX
FX reserves,
reserves, 2000
2000 to
to 2011
2011
All
figures
in
$
billion
All figures in $ billion
2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

Argentina

52

52

48

46

46

32

28

20

14

10

20

34

UK

56

49

38

42

47

39

36

34

29

31

29

34

USA

48

47

46

42

45

41

38

43

40

34

29

31

Canada

51

45

43

42

39

33

31

30

32

33

30

29

Peru

47

44

33

31

28

17

14

13

10

10

Hungary

49

43

41

33

23

21

18

15

12

10

10

11

Czech Republic

43

43

42

37

35

32

30

28

27

24

15

13

Sweden

41

41

40

40

39

39

39

38

38

38

37

37

South Africa

41

35

32

31

30

23

19

13

Egypt

27

36

34

34

32

26

22

15

13

13

13

13

Romania

34

32

28

26

25

21

17

10

Australia

32

33

33

29

24

53

41

34

30

18

16

17

Qatar

31

30

18

10

Colombia

30

27

25

24

21

15

15

14

11

11

10

Chile

33

28

25

23

17

19

17

16

16

15

14

15

Kazakhstan

32

25

20

18

16

18

Developed markets

2128

2061

1840

1841

1754

1684

1567

1547

1343

1111

996

1006

Emerging markets

7465

6930

6019

5206

4563

3386

2672

2152

1672

1321

1102

1015

EM Asia ex China

1997

1873

1666

1386

1394

1160

1011

972

814

666

565

535

592

526

436

380

349

222

182

163

146

119

119

124

1683

1550

1400

1397

1212

870

599

355

267

208

167

152

Latam

VI. APPENDICES

CEEMEA

Source: J.P. Morgan and national central banks/finance ministries

INTRODUCTION TO FOREIGN EXCHANGE

71

VI. APPENDICES

EUR/USD since 1970 (synthetic euro pre-1999)

INTRODUCTION TO FOREIGN EXCHANGE

72

VI. APPENDICES

USD/JPY since 1970

INTRODUCTION TO FOREIGN EXCHANGE

73

VI. APPENDICES

AUD/USD since 1970

INTRODUCTION TO FOREIGN EXCHANGE

74

VI. APPENDICES

USD/CAD since 1970

INTRODUCTION TO FOREIGN EXCHANGE

75

Related J.P. Morgan research on www.morganmarkets.com/GlobalFXStrategy


 Flagship FX publications
 FX Markets Weekly (weekly on Fridays)
 Key Currency Views (monthly)
 Global FX Strategy Product Guide
 Quantitative research notes
 Launching the revamped FX Correlation Analyser, Sandilya and Bouquet, July 12, 2011
 Tail-risk hedging with FX options, M. Bouquet, January 7, 2011
 Managing FX hedge ratios: a framework for strategic and tactical decisions, Normand, Franklin-Lyons & Sandilya, May 26, 2010
 The month-end effect in FX: small but predictable, Normand, Oct 23, 2009
 Alternatives to standard carry and momentum in FX, Normand, Aug 8, 2008
 Rotating Between G-10 and Emerging Markets Carry, J. Normand, Jul 9, 2007
 Hedging Inflation with real assets, Normand, July 28, 2006
 JPMorgans FX Barometer, J. Normand, Sep 2004
 Which Trade? Choosing tactical positions across asset classes, J. Normand, Jan 7, 2004
 Profiting from Market Signals, J. Normand, Mar 2, 2002
 Currency indices
 Rebalancing VXY & Introducing VXY Global, Normand and Sandilya, March 26, 2011
 J.P. Morgan Tradeable Currency Indices (TCIs), J. Normand, Jul 2, 2007
 Introducing the J.P. Morgan VXY & EM-VXY, Normand and Sandilya, Dec 11, 2006
 J.P. Morgan effective exchange rates: revised and modernized, D. Hargreaves and C Strong, May 30, 2003
 Training

VI. APPENDICES

 Introduction to Foreign Exchange Options, A. Sandilya and M. Bouquet, November 9, 2010


 Introduction to Portfolio Management, Normand, October 16, 2007

INTRODUCTION TO FOREIGN EXCHANGE

76

J.P. Morgan Global FX Strategy


J.P.Morgan
J.P.Morgan top-ranked
top-ranked in
in global
global
research
research

Global
Global coverage
coverage

J.P. Morgan Researchs global #1 rank in


Institutional Investor across dozens of sectors
confirms the banks leadership in economic and
market analysis.

and
and in
in FX
FX strategy
strategy
 #1 FX Strategy

Institutional Investor All-Europe 2011


Institutional Investor All-Americas 2010
 #1 Rates/FX Derivatives Strategy
Risk Magazine 2010
 #1 Japan FX Strategy
Euromoney Japan 2010, 2009 & 2008

Flagship
Flagship publications
publications

VI. APPENDICES

 J.P.Morgan Global FX Strategy covers markets

London
London
5 analysts
analysts (3
(3 macro,
macro, 1
1
5
derivatives,
derivatives, 1
1 technical)
technical)
Japan
Japan
3 analysts
analysts (macro)
(macro)
3

New York
York
New
5 analysts
analysts (3
(3 macro,
macro, 1
1
5
derivatives,
derivatives, 1
1 technical)
technical)

Research
Research distribution
distribution and
and tools
tools

 All research and tools available on


www.morganmarkets.com/GlobalFX Strategy
from four perspectives: macro, derivatives,
technicals and quantitative models. Core
 DataQuery data and charting for hundreds of
thousands of securities
publications include:
 FX Markets Weekly (weekly on Fridays)
 FX Correlation Trade Analyzer charts implied
and realized correlation across dozens of currency
 Key Currency Views (monthly)
pairs
 FX Daily Planet (3x day for Sydney/Asia,

Real Effective Exchange Rate Indices daily
London & New York Open)
levels on J.P.Morgan calculated real trade FX Techs (3x day for Sydney/Asia, London &
weighted indices for 45 countries.
New York Open)
 FX Derivatives Chartpack Notes (daily)
 Corporate Hedging Survey (quarterly)
 Hedging signals for overlay managers &
corporates (monthly)
 Japanese Retail Investor Tracker (weekly, in
English)
 Japan Daily FX Update (in Japanese)
 Foreign Exchange Topics (ad hoc, in
Japanese)
77
INTRODUCTION TO FOREIGN EXCHANGE

Global FX
FX Strategy
Strategy team
team
Global
London
John Normand

Head, Global FX Strategy

(44 20) 7325 5222

Paul Meggyesi

FX Strategy

(44 20) 7859 6714

Thomas Anthonj

Technicals

(44 20) 7742 7850

Matthias Bouquet

FX Derivatives

(44-20) 7777 5276

Sunil Kavuri

FX Strategy

(44 20) 7777 1729

Ken Landon

FX Strategy

(212) 834 2391

Kevin Hebner

FX Strategy

(212) 834 4254

New York

Niall OConnor

Technicals

(212) 834 5108

Arindam Sandilya

FX Derivatives

(212) 834 2304

Justin Kariya

FX Strategy

(212) 834 9618

Tohru Sasaki

Head, Japan Rates & FX Strategy

(81 3) 6736 7717

Junya Tanase

FX Strategy

(81 3) 6736 7718

Anna Hibino

FX Strategy

(81 3) 6736 8364

Tokyo

John
John Normand
Normand is
is Managing
Managing Director
Director and
and Head
Head of
of Global
Global FX
FX Strategy
Strategy for
for J.P.Morgan.
J.P.Morgan. In
In addition
addition to
to developing
developing the
the
banks
outlook
and
recommendations
across
foreign
exchange
markets,
he
develops
trading
models,
hedging
banks outlook and recommendations across foreign exchange markets, he develops trading models, hedging
frameworks
frameworks and
and index
index products
products for
for FX.
FX. He
He is
is coco- author
author of
of the
the flagship
flagship publications
publications FX
FX Markets
Markets Weekly,
Weekly, Global
Global
Markets
Outlook
&
Strategy
(GMOS)
and
The
JPMorgan
View.
His
team
was
ranked
first
for
currencies
by
Markets Outlook & Strategy (GMOS) and The JPMorgan View. His team was ranked first for currencies by Institutional
Institutional
Investor
in
2011
(All-Europe),
2010
(All-America)
and
2006
(All-Europe).
Investor in 2011 (All-Europe), 2010 (All-America) and 2006 (All-Europe).

VI. APPENDICES

Johns
Johns previous
previous research
research roles
roles at
at J.P.Morgan
J.P.Morgan have
have included
included European
European Head
Head of
of FX
FX &
& Commodity
Commodity Strategy
Strategy (2004-07),
(2004-07),
global
fixed
income
strategist
(2001-04)
and
emerging
markets
FX
strategist
(1997-2000).
global fixed income strategist (2001-04) and emerging markets FX strategist (1997-2000).
Prior
Prior to
to joining
joining the
the bank,
bank, he
he worked
worked in
in global
global fixed
fixed income
income strategy
strategy at
at UBS
UBS Asset
Asset Management
Management and
and in
in Latin
Latin American
American
economic
research
at
the
World
Bank.
economic research at the World Bank.
He
He holds
holds a
a BA
BA in
in Economics
Economics from
from Georgetown
Georgetown University
University and
and an
an MPA
MPA in
in Economics
Economics and
and Public
Public Policy
Policy from
from Princeton
Princeton
Universitys
Universitys Woodrow
Woodrow Wilson
Wilson School.
School. He
He is
is also
also a
a CFA
CFA charterholder.
charterholder.
INTRODUCTION TO FOREIGN EXCHANGE

78

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VI. APPENDICES

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INTRODUCTION TO FOREIGN EXCHANGE

79

VI. APPENDICES

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