Keeping it simple
For example, Deutsche Bank put out research in August 2006 that asked investors to consider the possibility that a systematic trading strategy could be run in such a way as to harness the market returns, or beta, that the bank’s researchers say exists in the foreign exchange market.
Beta is often measured by a benchmark index for a given market, so the risk and return produced by the S&P 500, for example, is the beta returns for the US equity market. Transferring the concept of beta on to currency trading, however, presents a number of issues, mainly because the concept of value in foreign exchange purely comes down to how one currency moves in relation to another. Unlike in the equity and bond markets, where the investor holds securities that have an intrinsic value, a static currency holding has no such intrinsic worth. Rather, foreign exchange holdings can only have value if there is a trading process attached to them.
Deutsche Bank set out to create a systematic trading process that would single out a type of FX beta and consistently extract it from the market. The bank says beta does exist in currencies thanks to the fact that people participating in the market can have substantially different objectives and beliefs, while a number of market participants will not be maximizing profit – companies for example that have to change money as they operate across borders.
The bank found that certain systematic trading strategies, such as one based on the classic carry trade, produced beta returns. It was then only a short step to constructing a formal investable index based on its algorithm, which could be sold as a structured note.
The Deutsche Bank Currency Returns index takes the three most widely used currency trading strategies – one based on carry, one based on valuation and one on momentum – and applies them in a rules-based fashion. For example, the strategy buys the top three yielding currencies out of the G10 and sells the bottom three based on three-month yields, with the position reassessed every three months.
Credit Suisse also relies heavily on its in-house research. It has issued several products based on its trademarked Holt Valuation Framework, a proprietary method of valuing companies. The framework aims to find a pure measure of economic performance, partly by identifying various accounting distortions then reversing them to come up with a figure for cashflow return on investment (CFROI), a metric established by the Holt designers.
The starting point is the premise that financial statements as presented distort the true economics of a business. Distortions arise because regular financial performance measures, such as price/earnings ratios, return on equity and earnings growth are highly unreliable, say Holt’s makers. Management can easily manipulate earnings, for example, by changing depreciation policy, taking assets off the balance sheet or taking special charges.
An index produced on the back of Holt, the HS60, uses a scoring system that rates companies from most attractive to least attractive based on the CFROI numbers. The index is rebalanced annually and forms the basis of a number of structured notes.