Intro To FX Slides

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%
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
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
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
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
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%
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
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
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
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
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
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
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
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.
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.
Currency regimes by 2020 more fixed or floating?
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?
10
PLN (10.5%)
CZK (6%)
EMU members?
Agenda
11
Monetary approach
Balance of payments approach
Asset market approach
Intervention
18
32
42
VI. Appendices
62
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%

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
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
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
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
06
11
74
13
79
84
89
94
99
04
09
Balance of payments approach: focus on particular current and capital account components
Balance
Balance of
of payments
payments for
for 2010
2010
All
figures
in
billions
of
USD
All figures in billions of USD
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
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
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
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
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
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%
-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.

17
Agenda
11
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
32
42
VI. Appendices
62
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
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
Fundamental
Technical
Fundamental equilibrium
exchange rate models
(structural variables)
terms of trade
productivity
government debt
net investment income
Purchasing Power Parity

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)
20
Long-term models: PPP versus fundamental exchange rate models
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.
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
60
BRL
JPY
NZD
EUR
AUD
CHF
ZAR
NOK
SEK
MXN
CAD
PLN
KRW
CLP
GBP
TRY
CNY
-20%
USD
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
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.
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
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
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
-20%
Guidelines for quantitative models
-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
25
Rule-based trading models: Carry

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

Pair
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
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
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
moved recently.
Parameters: (1) reference interest rate; (2) lookback
period for measuring change (3) rebalancing frequency

(daily, weekly, monthly)
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
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
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.
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
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%

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

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
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).
30
Performance: comparable to currency managers but lower than hedge funds
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
31
Agenda
11
18
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
42
VI. Appendices
62
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
2008
2008
2008
20%
0%
-20%
-40%
01
03
05
07
0%
09
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
garbage in, garbage out

model results frequently require discretionary
adjustment due to skewed results
Standard deviation
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
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

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
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

36
Lower leverage
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.
37
Lower leverage
Higher leverage
Directional trades: lower conviction and modest move in spot

Strategy
Example
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
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
Low leverage
Range trades
Strategy
Example
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.
39
Relative value trades
Strategy
Example
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.
40
Case study: constructing a model portfolio

Investable markets
All regions
All currencies
All instruments (cash, derivatives)
Inputs to the view
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.
41
Agenda
11
18
32
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
62
42
A decision tree for FX hedge ratios
V. MANAGING FX HEDGE RATIOS FOR INVESTORS AND CORPORATES
Currency
risk
Passive
management
100%
hedged
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
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
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
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+
-5%
-5%
8%
14%
4%
0%
7%
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
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
Other
47
Central banks match foreign liabilities with
foreign assets
Exception 3: Risk diversification from FX
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
48
Conditions for lowering portfolio volatility through FX exposure
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
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
-0.10
FX/asset vol ratio = 0.50
US and foreign equity markets are

-0.20
equally volatile
-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

-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
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
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
51
Choosing the optimal hedge ratios: one size never fits all
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.
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%
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)
53
Optimisation results
Optimal
Optimal hedge
hedge ratios
ratios to
to maximise
maximise IR
IR or
or minimise
minimise volatility
volatility
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.
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%
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.
55
08
Symmetric vs asymmetric benchmarks: 50% hedging is option of least regret

Performance
Performance with
with and
and without
without overlay
overlay
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 (%)
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
(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
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
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
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%
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.
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%
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.
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
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
-1.7%
5.8%
-0.29
-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
-1.6%
4.6%
-0.35
Hedged v ia Option
-1.5%
5.5%
-0.28
-1.4%
4.6%
-0.30
-1.2%
4.8%
-0.24
-2.6%
6.7%
-0.38
-1.5%
5.6%
-0.28
-1.6%
4.8%
-0.33
Unhedged
0.7%
10.5%
0.07
0.9%
5.0%
0.18
Hedged v ia Option
1.0%
6.2%
0.15
1.0%
5.1%
0.19
1.0%
5.6%
0.18
0.5%
8.6%
0.06
0.8%
5.9%
0.13
1.1%
5.5%
0.19
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
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
61
Agenda
11
18
32
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
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%
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
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
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.
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
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
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
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
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
71
VI. APPENDICES
EUR/USD since 1970 (synthetic euro pre-1999)
72
VI. APPENDICES
USD/JPY since 1970
73
VI. APPENDICES
AUD/USD since 1970
74
VI. APPENDICES
USD/CAD since 1970
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
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
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.
78
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VI. APPENDICES
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VI. APPENDICES
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Global FX Strategy

July 13, 2011

STRICTLY PRIVATE AND CONFIDENTIAL

I. Size, structure and management of global currency markets

Size and structure of global forex markets

II. Fundamental drivers of exchange rates

III. Modelling and forecasting exchange rates

IV. Common trading strategies for investors

V. Managing FX hedge ratios for investors and corporates

INTRODUCTION TO FOREIGN EXCHANGE

Size and structure of global forex markets

Forex markets are unique from four perspectives

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

(Auckland) to Friday night (New York)

Structure: largely over-the-counter

Government intervention: frequent, but more in

emerging markets FX than in major currencies

$4 trillion in average daily turnover across all

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

FX is the most liquid market in the world. For

comparison, daily turnover in equities (cash and

London accounts for 37% of turnover, or twice the

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

INTRODUCTION TO FOREIGN EXCHANGE

Forex markets are disproportionately dollar-centric

centric as legacy of Bretton Woods.

though US constitutes only 25% of the global

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

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

Chinese renminbi is grossly underrepresented in

global markets relative to the Chinese economys size.

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

USD is used in 85% of forex transactions even

nominal GDP, $bn

INTRODUCTION TO FOREIGN EXCHANGE

despite 40 years of floating currencies and more diversified trade patterns

AUD floated (from

RUB devalued, MYR repegged

THB, MYR, IDR, PHP, KRW

INTRODUCTION TO FOREIGN EXCHANGE

CNY refloated, VEB

Series of mini USD

August 1971 - March 1973

I. SIZE, STRUCTURE AND MANAGEMENT OF GLOBAL CURRENCY MARKETS

Any currency can serve as a reserve asset if it is

liquid, convertible and stable.

USDs dominance has been declining for a decade, but

Transaction demand: USD was involved in 90% of

forex transactions in 2001, compared to 85% in 2010

Reserve demand: USD accounted for 71% of global

reserves in 1999, compared to 61% in 2011

gap between reserve accumlation and official

INTRODUCTION TO FOREIGN EXCHANGE

foreign official purchases of US securities

global reserve accumulation

Making more reserve currencies

Reserve currencies must be liquid, convertible and

Many currencies retain value, but few will every offer

sufficient liquidity and convertibility to the worlds

Only four govt bond markets offer outstandings

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

are irreconcilable in an era of high G-10 deficits

INTRODUCTION TO FOREIGN EXCHANGE