Jul 03

BIS on Foreign Exchange (FRM AIMs in the news)

by David Harper, CFA, FRM, CIPM

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Highlights from last week's BIS annual report on foreign exchange markets. The headline is that August 2007 saw an abrupt jump in exchange rate volatility; e.g., the dollar/Euro nose-dived from 9% annualized depreciation to 20% annualized depreciation. August 2007 was a month of reckoning: we have an assigned reading about the temporary melodrama among quant funds for a few days in August (What Happened to the Quants in 2007?). Aside from the expected (higher commodity prices have contributed to currency volatility), I found these interesting:

Cross currency swap

"tensions also became apparent in the market for cross-currency swaps. These instruments are similar to foreign exchange swaps but are more liquid at maturities longer than one year and involve the swapping of interest payments as well as principal in different currencies. They are important for institutions that want to hedge longer-term offshore funding. Cross-currency swap prices for a number of currency pairs moved sharply during certain periods of heightened volatility. Prices for the euro/dollar and sterling/dollar pairs at the one-year tenor and above, for example, swung abruptly into negative territory from the end of August 2007 onwards, indicating a sharp increase in demand for longer-term US dollar funding." (BIS Annual p. 79).

Technically, (following Hull) we have defined a cross-currency swap as a fixed-for-floating currency swap. Specifically, the variations are:

  • Fixed-for-fixed currency swap
  • Fixed-for-floating currency; i.e., a cross-currency swap
  • Floating-for-floating currency

So that, in a cross-currency swap, there is deliberate exposure to both currency and interest rate risk. BIS says, "they are important for institutions that want to hedge longer-term offshore funding." For example, a U.S. based company is funding a long-term European project (maybe a European subsidiary is building an energy-related project). The cash flows (investments and lagged revenues) will be in Euros. Perhaps the company can borrow dollars more cheaply, so it borrows dollars by issuing a floating-rate dollar bond. Then the company enters into a cross-currency swap to receive floating dollars and pay fixed Euros. Now it has funded into offshore project, that will be generating cash flows in Euro, with a Euro-denominated obligation.

Carry Trade

"In the early part of 2007, the persistence of historically low volatility sustained the focus on prevailing interest rate differentials and carry trades as a major driver of exchange rate developments. In this environment, funding currencies such as the yen and the Swiss franc experienced downward pressure, while high-yielding currencies such as the Australian and New Zealand dollars appreciated. Because the term "carry trade" has been used very loosely in popular discussion, it is important to stress that it refers strictly to leveraged trades that exploit large interest rate differentials across currencies and low exchange rate volatility by betting on the failure of uncovered interest parity. In practice, carry trades are typically implemented through a combination of foreign exchange spot and swap transactions to obtain a "synthetic" forward position that is long the high-yielding currency and short the low-yielding currency. This is done synthetically, rather than through an outright forward position, largely for liquidity reasons. Importantly, such trades are leveraged because they do not involve any cash outlay up front."

The points here are:

  • Before August 2007, interest rate differentials were a primary driver of exchange rates. Since then, participants appear to prioritize "growth differentials." That is, they impound expectations about different economies. This seems to have at least two aspects. First, strong economic growth naturally leads to more demand for a country's currency. Second, participants may infer monetary policy; e.g., they may think stronger growth will lead to restrictive monetary policy (in order to curb inflation) and a stronger currency, or conversely, weak growth prospects may imply a loose policy, which in turn implies a weaker currency.
  • The "carry trade" aims to exploit the failure of uncovered interest rate parity. See yesterday's pots for an illustration of how failure in IRP can be arbitraged. (note mine is not the synthetic but rather uses the forward).

Structural explanations for increased FX transaction activity

The three structural reasons are interesting:

  • Growth in prime brokers: prime brokers have given hedge funds a means to more actively participate in FX markets
  • Growth in algorithmic trading; e.g., "small spot trades can be diverted to "auto-trading engines", freeing up human traders to spend more time on complex trades, while hedging trades can be automated to improve risk management."
  • Increased presence of retail investors

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