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FX debate, part 1 of 2: Making the most of a benign environment


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Low volatility in the FX market should not necessarily mean low returns.

FX debate: Executive summary

• FX is experiencing lower levels of volatility in a benign, low-risk environment but this is not necessarily a bad thing for the market and there are still opportunities to make money

• US sub-prime mortgage concerns should not be ignored but are not that big a factor to most market players. However, other areas of risk, such as geopolitical, need to be properly priced in and may not yet be so

• Emerging markets are an expanding asset class and offer a potential source of alpha but they require patience in order to spot the best opportunities

• Research is still an important service that banks can provide the buy side, which is always on the lookout for good ideas, but it needs to be carefully tailored and selectively distributed, not mass marketed

Part Two: FX Debate: How to keep the buy side on side
FX debate participants

Potential areas of risk include sub-prime and geopolitical factors, but most players see the current market and future outlook as benign. Use of quant analysis and research, together with a patient approach to emerging markets currencies, should provide plenty of opportunities for alpha generation.

AE, Millennium
Why is volatility at such low levels? Returns have been average for the past two or three years so do you believe this is going to change?

XP, FX Concepts
Different years favour different strategies. As certain strategies and styles do well, they attract people. As more people come on board, they crowd out the opportunities, so returns diminish and you get this drop off in the performance of a given trading style. Trending has done quite badly over the past few years. What’s done well is something with a completely opposite return distribution to trending, which is carry or stocks. There’s a natural cyclicality to it.

RL, Barcap There is an assumption that lack of volatility means an inability to make money. That’s not true. In 1999, when the euro was launched it dropped like a stone. But that coincided with the lowest point in euro/dollar vol that we’d seen. Had you been short euro/dollar the fall in vol would have been irrelevant. The issue of the past two years has been declining vol and lack of directionality. From a macro point of view most people expected the dollar, as a representative of the global imbalances, to get slaughtered, but that didn’t happen.

DT, FFTW I totally agree, currency managers crave directional movement, not volatility. Fund managers would be quite happy in an environment where a currency appreciates by a small, consistent amount on a daily basis – it is important to remember that volatility and direction aren’t necessarily correlated. I also think the concern among market participants regarding low volatility and the lack of direction is really driven by the recent experience in G3 exchange rates. Large fluctuations in exchange rates tend to occur when national economic cycles are out of sync. Increasing synchronization of monetary policies across Europe, Japan and the US implies that business cycles in G3 countries are more correlated. Given this backdrop, it really is not surprising that G3 exchange rates have been range-bound. If we expand our horizons to the rest of the G10 currencies, we would find much less business cycle synchronicity and a good deal more directional exchange rate movement. In 2006, the New Zealand dollar depreciated more than 10% versus the US dollar from January to March and then rallied all the way back in the second half of the year. There are always opportunities in currency markets, the key is to have a large opportunity set.

PL, ABN Amro AM Lower volatility doesn’t mean the market is less risky, because correlation between currencies is now higher than what it used to be between G4 currencies. The difference is that the risk is now less apparent to the final investor as volatility has been replaced by contamination risk.

It is clear that currency managers have not generated much alpha in regard of what was expected. There are, however, some reasons for this. We’ve been through a disinflation period that drove most investors toward the same portfolio allocation: long bond, long equity, long commodities and emerging markets. Bearing in mind the Goldilocks scenario of low interest rates and inflation, there has not been much of an incentive or rationale for investors to shift their asset allocation drastically. Clearly, that’s not conducive to large cross-border flows and change in currency valuations. We feel this equilibrium will be disrupted at one moment either by inflationary pressure or possible monetary policy mistakes by central banks. This probably could trigger higher volatility and higher opportunities for currency managers.

RL, Barcap A number of central banks have supplied volatility to the market in never-before-seen quantities. It may be mildly asymmetrical, but they are effectively trading gamma. Particularly in the euro/dollar, that adds to the containment effect. The value in the wings is increasing, not lessening, but it is going to be low distribution.

The present environment of perceived low volatility/low risk does not do good service to the end investor. It is generally a good thing to have some explicit risk premiums in markets as it drives investors toward more diversified portfolios and therefore better-quality risk adjusted returns. Clearly we are at a point where we swapped explicit risk, ie, volatility, for correlation risk, which is more difficult to estimate and to hedge.

MT, RBS With the opening up of the primary markets via prime brokerage and the addition of new electronic communication networks, some of this low vol environment may be due to these new pockets of liquidity that aren’t monitored effectively. Moves in the market seem to be absorbed more than in the past, the hot potato effect of a new order has less impact as it makes its way via non-traditional channels.

BT, JPMorgan You see the same low volatility environment in other asset classes, so there are clearly some other elements to be considered other than the increase in electronic trading platforms.

AE, Millennium
So would these new market participants and this additional liquidity affect potential future foreign exchange moves? Or is there so much liquidity driven by these central banks that volatility as we knew it has gone?

Arguably, the FX market is a derivative of the global economies, which currently are reasonably synchronized. At the simplest level, currency moves happen because of interest rate or inflation differentials or poor budgetary situations. Since the crises of 1998, governments have pursued much more transparent policies and there’s better coordination globally. You are not getting the mismatches in inflation or interest rate differentials, and you see that same issue manifesting itself in the bond markets.

AE, Millennium If you’re right we’re going to get a lot less volatility.

JA, State Street
Less volatility’s not necessarily bad. There are strategies which will survive and thrive in such regimes, as carry has. Some currency return distributions are bad for momentum strategies, but they are good for others. It is vital to understand what kind of regime is producing these distributions therefore, if you are going to attempt to predict which strategies will succeed going forward. We take a multi-factor style approach to our research. Carry as a style factor has been doing exceptionally well – precisely because it is a style that performs well in a regime where liquidity abounds.

KMc, Westpac One reason for the low FX-volatility environment is that the regular retail client has been using yield enhancement strategies. The increasing use of structured products is one reason we are seeing a compression in volatility. The retail sector in Japan, through the use of structured products, which uses a lot of exotic options, and the associated gamma and vega hedging that the banks need to undertake as a result, is artificially pushing down volatilities. The retail side is becoming more knowledgeable on FX and the various products, and access to FX liquidity is easier than it’s ever been. The impact from the structured product part of the business is increasingly important and will continue to be a significant influence in FX.

AE, Millennium Are we in a situation of dampened-down volatility with pockets of unbelievable volatility when fundamentals reassert themselves, as in the last few weeks? Or are we now exiting this benign environment where we will now see FX participants in many strategies benefit?

The environment is still benign, and in terms of foreign exchange returns in aggregate, exchange rates haven’t moved much over the past few years. Levels are similar to the end of 2003. There’s been plenty of noise, but nothing in the shape of sustainable trends. For trends in foreign exchange, you need macroeconomic dislocations across countries which we don’t have.

RL, Barcap You need event risk. That is why everybody’s focusing on sub-prime.

KMc, Westpac
There’s massive geopolitical event risk that’s not being factored in. While catalysts are difficult to predict, this increases the risk of sharp market sell-offs – for example what happened to the carry trades in late February/early March this year. There are issues in North Korea, China, Iran and Iraq that the market seems complacent about and, to top it off, concerns of a blow-up in the US housing market.

AE, Millennium Isn’t this just a non-systemic sub-prime scenario and deep down we’re simply in a benign environment?

BT, JPMorgan
There are different views on whether we are going to see recession or a soft landing in the US. Some players are concerned about inflation, others about recession. Some believe the rest of the world can grow despite a slowdown in the US. There’s a wide bid-offer on banks’ forecasts for interest rates. Geopolitical risks may not be fully priced in to asset prices. Increasing protectionism is another risk that is not often mentioned. There is a lot of noise about sub-prime lending. Credit conditions in the US will tighten. Will this spill over into the private equity space if players begin to feel we are at the top of the credit cycle? How does this affect financial sponsors and what happens if this all takes place as the US is entering a period of lower growth, rising interest rates and inflation?

AB, GSAM Sub-prime will not become a systemic issue. We believe the US housing market will be more of a drag on US growth for longer than we’d thought, and that has implications for Fed policy. In terms of global risks, apart from Iran, what concerns me is the potential for protectionism, given the importance of China and the fact that their business model rests on dumping a lot of stuff into the world economy. If we go into another slowdown, what would be the impact of that?

RL, Barcap I see three areas of risk. First, political risk; specifically protectionism. The creation of the global imbalances has rested on willingness for open trade. That only works while politicians don’t feel an obligation to close doors, specifically within the west. If that transfer mechanism is closed, there will be massive dislocation.

The second area of risk is sub-prime. Barclays’ house view is that it’s benign. As an individual I have reservations about the assumption that just because it hasn’t gone berserk yet, it can’t get worse in the future, particularly as interest rates have come up and the kickers and the deferred ratchets are coming in. The third is the re-emergence of Japanese inflation. If there’s an increase in Japanese rates, that’s the biggest risk.

DT, FFTW There are always geopolitical risks and it’s never easy to price them. It is very easy to forget that the rally in global asset prices over the past 25 years was sustained through the Cold War, the collapse of the Soviet Union, and steadily increasing instability in the Middle East. Sub-prime is an issue, but it is not clear that sub-prime borrowers are very important to US consumption. Consumption growth has been extremely robust despite lacklustre performance by discount retailers such as Wal-Mart. This tells us that people at the lower end of the wealth spectrum are getting hurt, but US consumption is resilient. We’re definitely in a benign environment.

MT, RBS The sub-prime issue is relatively benign. But it is a period of low volatility and therefore people put on bigger risks to get the same returns. If there was to be a ripple effect of sub-prime mortgages or some other event that caused volatility to increase there could be a risk of a liquidity crisis. The algorithmic trading price-makers and market-makers are helping support some of the market whether we like it or not. If they go away in a time where people are trying to shift out of large risk, we may see the role of the banks as a risk transfer agent and relationship become even more important. But it’s benign at the moment.

CK-G, SGCIB I would highlight one remote risk, which is that of a possible "credit crunch". This issue arises because the hedge fund industry is leveraged in credit and Basle II is now with us. Under Basle II, as a bank, your capital allocation for credit increases when the credit that you are funding gets downgraded, so you have, in effect, a negative convexity in terms of capital allocation. If that were to happen and coincide with a deleveraging from the hedge fund community, it could cause a severe dislocation in the economy. That is not priced in.

XP, FX Concepts I’d bring up dollar risk. It’s extraordinary how a 7% current account gap for the US is not a problem. At what point will it be?

AE, Millennium How are we going to make returns in emerging markets and do you see the emerging currency world as an expanding asset class?

KMc, Westpac
In Asian emerging markets, which is Westpac’s focus due to our knowledge of the region, one of the key drivers is when Mr and Mrs Sakakibara in Seoul take out their mortgage in Taiwanese dollars. The carry trade impact even intra Asia is enormous. For example, Taiwanese appetite for foreign investment, the amount of business that’s being done, the transparency in the market now, better pricing, increases in liquidity, the uptick in market players, the availability of quality product; all of which have increased rapidly in the last few years. It worries me that the demand there is so large that it’s changed the market – particularly given the increased appetite of central banks both in Asia and Eastern Europe.

AE, Millennium So where are the opportunities?

KMc, Westpac
Asian FX is being approached in the same way as G10. At Westpac, due to customer demand, we’ve created an Asian currency model. For investors, bid-offer spreads have contracted so the cost of transacting has come in. The amount of product available, albeit still patchy, has increased, so it’s a more attractive market. Also, from a modelling perspective, the quality of data releases has improved, making it easier to do quantitative analysis.

BT, JPMorgan Speaking about Latin America, Brazil seems expensive. In a US downturn we may get better entry points. Meanwhile, in light of today’s economic backdrop, volatility is at historically low levels. If you look at Argentina, Peru and Colombia you see artificial volatility around those currency pairs – due to central bank intervention. Timing is key. Those trades could be attractive in the event of sustained US slowdown or repricing of risk.

AE, Millennium For the larger investors there are about 10 emerging currencies that make sense. Do you see opportunities diminishing as more investors chase the same returns or will the ever increasing emerging options market in fact increase the opportunities?

I love emerging market currencies. They’re an essential part of any FX manager’s opportunity set. The future returns available could be less than we’ve seen, simply because carry across the emerging universe has come down, and some of the attractive valuations that were a result of dislocations in emerging markets in the late 1990s have been eradicated. That said, the fundamentals we try to analyse seem to be more helpful in predicting movements in emerging market currencies. In the developed markets I struggle to explain a lot of the moves, let alone predict them. In the emerging markets the stories are more compelling.

AE, Millennium So how scaleable are they?

Very. I think about large currencies and small currencies, and I’d rather have a billion dollar Korea than a billion dollars of Kiwi, for example. Sweden and Norway are not especially liquid currencies, whereas the liquidity in the larger emerging currencies is fantastic.

AE, Millennium
What about combining credit decisions with the currency decision to increase your return profile?

It’s one thing to be tactical, but emerging markets are a place where it often pays to be passive. While there are certainly risks associated with EM currencies, it is probably the last place in the world that you’re getting paid a reasonable amount in yield terms to take risk. If you think about emerging market blow-outs, such as Argentina in 2002, Turkey in 2001, Brazil in 1999, it took less than 18 months and often less than a year to make back your money. In crisis periods, even large EM markets become illiquid. Investors need to manage risk pre-emptively by appropriately sizing exposures so that they can passively ride out crisis periods and let the risk premium work in their favour.

RL, Barcap You don’t always have to trade them from the long side. There have been some great short-side trades this year.

AE, Millennium
How do you think liquidity in emerging markets compares with G10 currencies? Is liquidity deeper in emerging currencies than is perceived?

KMc, Westpac
I hope so. You need the niche and specialist providers that are able to access pockets of liquidity and banks that understand the real drivers in the local economy – something you can’t get without doing business on the ground. You need people in the rates market who can look at their mortgage books, have access to that information and know what’s coming up in terms of funding and liquidity. For example, New Zealand can be the most liquid currency in the world within certain pockets, but the problem is understanding where to look and how to access those liquidity points.

Niche providers

AE, Millennium And the niche providers are the ones that know where to find those pockets?

KMc, Westpac
They have a much better grasp of that and order books that contain local market participants that only deal with their local banks.

BT, JPMorgan
In emerging markets it is key to be able to access both onshore and offshore liquidity. Recently there has been a fairly good amount of two-way investors flow. There might be more liquidity in times of turmoil than on days when the market is quiet. Ironically, getting in could prove to be more difficult than getting out.

KMc, Westpac
It’s the same with Scandinavia. Many players talk to Scandinavian banks, because they can price and access liquidity that the larger banks can’t.

When things work well you get the impression of tremendous liquidity.

We haven’t had a big dysfunction in emerging markets for a while, and when it happens the deleveraging will be horrible. But I agree that the niche banks, because of their access to unique and local flows, eg, corporates and local authorities, can sometimes provide better liquidity, particularly in the Nordic countries. But if I look at the market capitalization of the biggest Nordic banking groups and the average player in the top 10 banks of the world, it’s a multiple factor difference. There’s going to be a problem in liquidity provision from these organizations when it does turn nasty.

JA, State Street The active currency business got built up around currency overlay where the exposures you’re allowed to play in were defined by the asset markets. Hedge funds convinced the buy side to get away from investment constraints, and in currency that means untying positions from the underlying asset markets. That’s led to a sea change in liquidity. The cap-weight mindset is irrelevant. If you have a currency programme, what’s a sensible way to think about weighting? Some sense of liquidity seems to be the answer. In the equity market, market cap’s not a bad proxy for liquidity, but in currency it’s different.

AE, Millennium How important is FX research in investment decisions?

JA, State Street
Very important. The market structure’s changing. There’s a lot more focus on where each institution creates value. State Street provides information and advice based on that information that would be difficult to replicate within a buy-side firm. That’s true in currencies and other asset classes as well. We try to create value, through information and analysis of information. Fundamentals are a part of that, but there are a lot of good economists on the buy side and the sell side. We analyse the information about institutional investor behaviour, which we aggregate through our asset-servicing businesses. For instance, positioning is interesting. The markets react to a butterfly in China one week, and what you would think a priori a more significant event in another period of time the market passes by in very sanguine mood. That has a lot to do with investor positioning. If investors have their most extreme position for the last 10 years, it takes a much smaller piece of news to move markets.

PL, ABN Amro AM We utilize two types of research. One of a more quantitative nature so as to develop and challenge the tools we presently use in our investment process. The other type of research that we look for is of a more fundamental nature and helps us in supporting the qualitative part of our investment process. It is fair to say that we have quite a broad use of research provided to us by banks as our investment process is a blended style where research feeds at numerous levels such as forecasting, portfolio construction, risk management, etc.

AB, GSAM We’re avid consumers of research. Everything from State Street flow information to economic analysis put out by country economists at different banks, to weekly FX-specific publications, and even broader equity and fixed-income market publications as well. I’m looking for a nugget that makes me think: "That’s interesting. What does that mean for my positions?"

DT, FFTW I’m looking for that nugget too, but FX sales people often only send us FX and economic research. I’m also interested in what equity strategists have to say and why. I look for the nugget that’s been missed in the FX market.

XP, FX Concepts
We build models to identify those opportunities. Their success depends on the phase we’re in. If we’re in a convergent phase, things like bonds, dividend paying equities, carry, which have a very similar return distribution profile do well, then that’s easy. You park your money in the bank or you buy your Turkish T-bill and collect your carry, coupon or interest rate. Trends in FX generally emerge when things are not doing so well and there are dislocations. This is where cycles analysis comes in. If we look purely at price, there are trends. But all trends are subject to reversals. Cycles analysis is an effective way of picking those out.

AE, Millennium So how does your research differentiate you from your competition?

BT, JPMorgan
The branding of our FX research team differentiates us. Our analysts and strategists deliver the firm’s view from a trading, sales, marketing, structuring and risk-taking perspective. In addition, our clients rank the analytics available on our website as best in class. At the time JPMorgan created value at risk (VaR) and risk management in today’s world is an important topic for most of our clients, including hedge funds.

RL, Barcap One issue that some competitors face is that within foreign exchange they don’t own the FX call. It’s subordinate to the view of the chief economist. I think there should be ownership of the call. While you have to have a synthesized view, you cannot have a situation whereby the view is completely subordinate to: "We think US rates are going to 6%". Other people may disagree and the consequences for currency may not be what the chief economist thinks, particularly when not an FX specialist. Having ownership of that call is important, but you also need to understand that it is the nugget of information that’s important, not the: "This is what is going on in every country". Currently carry matters. So is this going to unwind? What are the triggers? We focus on this type of question in our weekly. That’s where we add value, and some of the quant analysis in creating a portfolio based on specific parameters is a strength for us. It’s about knowing what you’re focusing on.

KMc, Westpac Who owns the call is critical. That’s why we have two groups, strategy and economics. Our strategy team is independent. The members make their own calls. They trade and put risk where their mouth is both in terms of their macro views and backing our Westpac alpha model. It adds credibility that we have the confidence to back our team with capital. Banks have to focus on creating and attracting the alpha into portfolios and trading ideas are key. You have to put strategies together that you believe in and make your clients money. Adding value isn’t a nice thing to have – it’s critical to remaining relevant.

AE, Millennium I admire strategists/economists who are consistent, even when the markets are not agreeing with them. It is easier to follow their reasoning and many times they are correct in the long term.

At RBS we do research and strategies while trying to concentrate on what matters to our clients. With markets being so range-bound lately we have seen a lot more interest in shorter time horizons. Our emerging markets research team have a strong following as they take a hands-on approach looking at what’s going on in the local economies, giving our readers a ground-floor view. We also have a great team of quants that do specialized analysis and provide a unique set of interactive tools and heat maps for clients that let them spot opportunities based on historical data. That’s very popular in this quant-hungry, data-driven environment.

CK-G, SGCIB We think that investors want a forecasting process that is both transparent and consistent and that’s a difficult balancing act. For example, when you take a global view and your economists formulate their interest rate forecasts, you come out with a series of implied currency forward levels: you have to have a strong currency strategist to go against the implied forwards produced by the interest rate guys. Your process needs to balance this. We use a combination of macro modelling, and a black box or quant approach. This gives you a framework within which you can say: "This is what our multi-factor interest rate and economic models are throwing out"; and: "This is what my black box model throws out and this is its track record of success". This provides our clients with a broad forecasting framework, a framework against which we can modify the shorter-term views when necessary with the market perturbations and oscillations, that is, strategy. This approach has given us the flexibility to support the different needs of our various institutional and corporate clients over both the medium term and shorter term, and this is what they are demanding.

JA, State Street You have to focus on the long term as well. You mustn’t think that just because you’re writing every week everything has to happen within that week. That balance is crucial.

RL, Barcap
While there was broad agreement that it was a benign environment, I’m worried. Were I still trading, I’d assume the continuation of the carry in the short term, with the possibility of a nasty blow-up down the road. I’d be trading a two-month view and a one-year view. That has to be reflected in the research.

It’s interesting to see what clients do with research. There’s the quick money that takes the research and trades as soon as you walk out the meeting. There are the currency overlay funds that may only move once a month. Then there’s the corporate business that may move quarterly. An idea seems to go in three phases – hot money, real money, corporates. If you can time that, you can trade that delay in the market coming from those different investment types.

XP, FX Concepts Where we believe we add value is in how we use forecasts. We build a forecast using technical models but other people might quantify fundamentals. Once we have built the forecast, we run it through a series of filters. We use a portfolio approach and rank trades based on expected return versus risk giving us an expectation of the best risk-reward ratio per currency pair. Then we look at the correlations and filter out highly correlated trades to avoid doubling up on an idea. Research should tell people what is the most appropriate or the least risky way of expressing a view.

JA, State Street For an investment process, there’s the forming of the return expectations, which you called research. Then there’s portfolio construction, out of which comes investment ideas, which is strategy. The challenge for the sell side is the explosion in different kinds of strategies clients are now running. You’re speaking to a much more complex and disaggregated audience than five or 10 years ago.

MT, RBS It is hard to tie up your research and strategies with your execution tools, especially when they are cross-product. That is one of the areas we are going to concentrate on over the next year. In Greenwich our website allows our clients to hypothetically buy or even sell an idea, allowing clients to see very clearly how well our strategies have performed over time. And even now in the new product suite we are trying out ways to put together dynamic strategies like carry trade indexes where you can organize your own basket based on the correlations, and then do "what if...?" scenarios to analyse what would happen.

PL, ABN Amro AM What differentiates us is I feel the recognition in our investment process that models are generally good but that they also cannot capture all the dynamics of the foreign exchange markets. Throughout the year we have managed to develop our investment process in such a way that our investors get value from the quantitative model that we have developed but also from the experience and judgement of the professionals that support the process. This balanced blend between quantitative and qualitative has allowed us to deliver top quartile performance.

AE, Millennium How do you generate incremental returns from managing FX?

We always challenge ways we create value for our investors. I see a lot of research about timing the market, but little about portfolio construction. This is a shame as I feel there is a lot of value that could be added there. Building portfolios resilient to short-term volatility is critical when you aim to add good-quality risk-adjusted returns.

XP, FX Concepts We looked at G10 and then we broadened our analysis to emerging market currencies as well. Our principal component analysis showed that the return streams from trading G10 last year were coming from two principal components, the dollar against something and the yen crosses. If you broaden that out and build a portfolio, which includes emerging market currencies, you’ve got about eight different drivers of return, which explain about 80% of the variance of the portfolio. That’s great, because you can have all sorts of different things going on and your portfolio is getting hit on one-eighth of it say, but not on the rest.

AB, GSAM It’s important to have a diversified approach, both discretionary and quantitative. There’s a number of different ways that you can link those. One is to have a quantitative model where someone looks at the output and decides which parts to go along with. That’s how we developed a quantitative approach in the mid-1990s. However, we tended to go with the bad signals and ignore the good ones. So a better way is to have two separate groups, one dedicated to a quantitative approach. The human element comes in designing rather than interpreting the model. Then you have a judgemental unit working alongside that. We allocate a 50% weight to each of them.

DT, FFTW We’ve adopted a similar approach – we split the systematic and judgmental risk taking. A large proportion of the value added from systematic strategies is the discipline. We all know how bad it feels when dollar/yen has gone five big figures in your face. The model can look at it and say: "That’s bad, but how far has the portfolio gone relative to historical volatility? How bad is it historically? And if it’s not that bad, we’ll stick with it". On the alpha side, we tend to favour models that capture a fundamental economic relationship because these linkages are more likely to persist. The value comes from asking what kind of a world we live in – benign, so growth differentials matter, yield differentials matter, and relative trends in monetary policy matters – and design models accordingly.

AE, Millennium Do you ever change the weightings within your models?

We tend not to. Our styles of quantitative management are uncorrelated over time. It’s partly by design, because we only add something if it’s diversifying. Within the modelling process there’s a lot of discretion. It’s disingenuous for us to say that models are totally objective, and there’s no judgement or emotion in it, when you’ve spent six months leading up to the completion tearing your hair out over whether PPI or CPI should go into the model.

KMc, Westpac There are so many types of modelling available. At Westpac, we have created an alpha model based on five sub models – carry, flow, positioning, risk appetite and economic sentiment. We trade an unweighted portfolio of the five with a real time information ratio of +1.0

AE, Millennium
Currency managers have consistently outperformed their benchmarks, unlike equity or bond managers. Why is this do you think?

Transaction costs in FX are much lower than in equities or bonds. There are more currency markets to exploit than bond markets. The barriers to entry are easier than trying to maximize value from the bond market. You can do the alpha a lot easier. Currency markets trend more than bond markets, and when the moves happen they tend to be bigger percentages, so you can jump onto markets that trend more. When a currency moves dollar/yen it moves 10% to 20%. Bond markets don’t move 10% to 20% unless you get 9/11. You have an opportunity set that’s easier in currencies where you can do better.

JA, State Street We should also remember that for most participants in the currency markets FX is a by-product of other activities, such as selling goods overseas, building a plant, M&A. As such, they are not profit maximizers on their currency trades. This presents opportunities for others, who are, to create alpha. Central banks also play a role that is unique in currency relative to other assets in systematically (ie, predictably) hindering prices from adjusting to their market level.

AE, Millennium Equally what makes currencies interesting is that within the product itself there is alpha to be obtained from so many different areas. For example, some managers purely look at 24-hour price action whereas others look at purely long-term trend signals. The opportunities are endless.

RL, Barcap
Barclays Capital launched the ICI in November. We are invested ourselves. Carry has had its worst period since 1985, and the ICI had a sharp down move, having hit a peak before the collapse. But a model like the ICI showed positive returns, even in that downturn. Even when you might expect the model to blow up or not perform, they are performing. Some models return alpha, even when they’re not expected to.


AE, Millennium So what innovations can we look forward to in the future?

I think you accommodate for the environment. Certainly fewer systematic funds are calling in to sell vol in the short term. They’re more inclined to innovative ideas in the vols market and in e-commerce. More hedge funds are now turning to pure vol products for systematic trading of volatility. This makes sense from a modelling and execution perspective since vol products are actually simpler than vanilla options, easier to track P&L, and achieve the desired position over all spot levels and time to expiration. Perhaps pure vol products will be an easier transition to e-commerce than vanilla options since they are more similar to spot than vanilla options.

BT, JPMorgan Volatility seems to be trending. It is at almost all-time lows. EM currency volatility versus G10 volatility is also at historical lows. With the lack of a clear and discernible trend in the FX markets we believe investors will be more willing to play in the volatility space. We have seen this occurring in the past in the equity derivatives market. Investors are now looking to exploit these opportunities in FX, to take advantage of the less expensive volatility levels.

DT, FFTW But as fund managers, we’re paid to take risk. If you hedge everything away your alpha’s going to be zero excluding transaction costs. Volatility is interesting and it’s something that you can play tactically, but it’s almost too good a hedge for carry strategies. Carry strategies are generally short volatility. If I hedge my carry portfolio with a dollar/yen forward volatility agreement (FVA), the FVA will tend to work when carry is down and it will tend to drop in value when carry is generating returns. It’s not clear to me that the net returns will be positive. We have to be innovative, but we should resist throwing out what has worked for a long time just because it hasn’t been working for the last three years.

JA, State Street In terms of our research products, we are continually striving to deliver added value, in terms of helping our clients succeed: we have clients who just want our information, others want quantitative models that trade off the information, still others want us to interpret the information for them. All are perfectly valid value propositions – but each needs a quite different service model.

RL, Barcap Innovation is going to help with looking for that nugget which drives an idea. You have to synthesize a lot of information, a lot of inputs, and people will increasingly look at hybrid product. That’s one way in which the market is being driven, particularly in the options product. The mechanism for dollar/yen going down in the face of Mr and Mrs Watanabe doing their yield enhancement products is simple. Lower US rates. And I think you’ll get a double whammy. What drives that? Let’s take sub-prime. You have the catalyst of seeing substantially lower rates in the US, which will also take dollar/yen down. If you’re prepared to do it, you get a substantial discount.

AE, Millennium To use a racing analogy, rather than just go for the win, you’re going for first and second; a dual forecast?

RL, Barcap
Yes. You’ll get some movement in the currency, some movement in the yield, and on top of that you’re getting the correlation. It’s at 30-odd percent, and the market’s short of that correlation, so it’s probably about 40 offered. But if you look at the way in which it behaved before the deflationary period, you’re likely to see a more correlated move.

AE, Millennium What’s the bid-offer spread on these? It’s all very well getting in. What’s the impact on you getting out?

RL, Barcap
If you ask for a price, and make a price, the bid-offer is going to be wide, but as soon as you get in, the mid market is the bid because I can’t source it anywhere else. So I’m keen to get it off.

AE, Millennium
So you basically have a P&L loss the moment you put a trade on but the investor is aware of that?

RL, Barcap
Yes, but you have a situation in which that is likely to increase, because you are being offered the opportunity.

AE, Millennium
But if I asked four counterparties for that price, would there be a huge variation?

RL, Barcap
I don’t think so but there are not a lot of people capable of making the price.

AE, Millennium
How many banks are doing these correlation trades? And I assume it is the macro community rather than foreign exchange specialists doing them?

RL, Barcap
It is macro but it’s also realized volatility. I looked at it from a dollar/yen point of view but you could flip it on its head and say that it was a rates view with a kicker in dollar/yen. As you get these increasingly interdependent markets, it is not enough to look at foreign exchange or to look at rates or to look at commodities as a stand-alone. The way in which everything needs to be considered means people increasingly look at the hybrid product.

The discussion continues (Part 2 of 2)