Forex

Finance 490-402: Alternative Investments – Nov. 6, 2013

1

Finance 490-402: Alternative InvestmentsFall 2013

Currency

1. What is currency?2. Foreign exchange market3. Exchange rates4. Currency trading styles

http://img1.findthebest.com/sites/default/files/419/media/images/University_of_Kentucky.jpg

5


Currency – Money Supply

Central banks have control over the amount of money in issuance. However, the amount of money in existence at any given moment can be difficult to measure.

M0 money supply: this is lowest and most liquid form of money and it only includes the actual amount of coins and paper money in circulation.

Monetary base: includes M0 as well as bank reserves held with the Federal Reserve.

M1 money supply: this includes M0, plus all demand deposit accounts at commercial banks.

M2 money supply: this includes M1, plus all current accounts at commercial banks such as savings accounts, and checking accounts.



6


Currency – Monetary Base


4/1/1

970

10/1/1

971

4/1/1

973

10/1/1

974

4/1/1

976

10/1/1

977

4/1/1

979

10/1/1

980

4/1/1

982

10/1/1

983

4/1/1

985

10/1/1

986

4/1/1

988

10/1/1

989

4/1/1

991

10/1/1

992

4/1/1

994

10/1/1

995

4/1/1

997

10/1/1

998

4/1/2

000

10/1/2

001

4/1/2

003

10/1/2

004

4/1/2

006

10/1/2

007

4/1/2

009

10/1/2

010

4/1/2

012$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000 US Monetary Base

USD

(Mill

ions

)


8


Currency

Floating vs. fixed currencies

Floating currencies are those that are allowed to trade openly, and whose value versus other currencies can change according to free market supply and demand characteristics.

Fixed, or pegged, currencies are those which the issuing government manages to maintain a constant value versus another currency. This monetary system may be tied to a global reserve currency, such as the US dollar, or to a fixed amount of gold. Pegged currencies require the central bank to manage the currency (printing or buying currency, raising or lowering rates, and often enacting capital controls) in order to keep a steady exchange rate.



9


Foreign Exchange

Foreign exchange (Forex or FX) market is an exchange for the global, decentralized trading of currencies.

Financial centers around the global function as centers of trade, usually via large securities dealers or commercial banks. There are several interbank electronic platforms that allow for direct, electronic trading between market participants.

FX markets trade 24 hours a day, except for Saturday and Sunday (Greenwich Mean Time). The current forex markets have their foundation in the 1970s, as restrictions on currency transactions were eased and countries around the world went off the gold standard.



10


Foreign Exchange

The foreign exchange market is the most liquid market in the world. Over $4 trillion dollars worth of trading occurs each and every day. Notional amount is around $66 trillion.

Foreign Exchange Markets

Daily Volume ($ Bil)

Forex swaps $1,750Spot market $1,500Forwards $475Options $225Other $50

Foreign Exchange; 10.4%

Interest Rate; 77.3%

Equities; 1.0%

Commodities; 0.5%

Credit Default; 4.2% Other; 6.6%

Global Derivatives Notional



11


Foreign Exchange

Market Share

1 Deutsche Bank 14.6%2 Citi 12.3%3 Barclays 11.0%4 UBS AG 10.5%5 HSBC 6.7%6 JPMorgan 6.6%7 Royal Bank of Scotland 5.9%8 Credit Suisse 4.7%9 Morgan Stanley 3.5%

10 Goldman Sachs 3.1%

Forex Dealer

Daily Volume



12


Currency

Currencies are often divided up into two large categories: G10 and everyone else (mostly emerging markets). The G10 currencies are considered to be the most liquid markets in the world, and typically are from stable political and open economic regimes.

G10 Symbol

Australian Dollar AUDBritish Pound GBPCanadian Dollar CADEuro EURJapanese Yen JPYNew Zealand Dollar NZDNorwegian Krone NOKSwedish Krona SEKSwiss Franc CHFUnited States Dollar USD

EM Symbol

Brazilian Real BRLChinese Yuan CNYColumbian Peso COPIndian Rupee INRIsraeli Shekel ILSMexican Peso MXNPolish Zloty PLNRussian Ruble RUBSouth African Rand ZARThai Baht THB



13


Exchange Rates

One interesting point about currency is that there is no such thing as an independent long or short position. Any currency trade can only be defined relative to another currency. That is, all currency positions are pairs trades. These pairs trades are referred to as exchange rates.

An exchange rate will be quoted as:

EURUSD = 1.2897

This means that every €1.00 Euro will purchase $1.2897 US dollars.

USDJPY = 94.5100

This means that every $1.00 USD will purchase ¥94.510 Yen.



14


Exchange Rates

EURUSD 1.3500 4.7%EURUSD 1.2897 0.0%EURUSD 1.2500 -3.1%

USDJPY 97.0000 2.6%USDJPY 94.5100 0.0%USDJPY 90.0000 -4.8%

EUR weakens, USD strengthens USD weakens, JPY strengthens

EUR strengthens, USD weakens USD strengthens, JPY weakens

When a currency pair moves, it means one currency strengthens and the other weakens.



15


Currency – Spot Market vs. Forward

Spot market involves the immediate transfer of actual currencies. Essentially, you are exchanging the currencies for each other at the point of sale. If you hand over US dollars to a currency exchange and you receive Mexican pesos, this is the spot market.

This is different than a future or forward contract, which is agreeing to exchange at a give rate in the future. Most currency trading is via spot or futures.

Swaps are slightly different…



16


Currency – Swap Market

Currency swaps are over-the-counter transactions, and unlike other swaps, they can involve the actual transfer of amounts between counterparties. This is usually referred to as an FX swap.

Currency swaps will include not only the notional transfer, but also an interest rate swap as well since interest rates in the different countries will be different.

A B€100,000

$128,970

A B€100,000

$128,970

2% on $

5% on €

FX Swap

Back-to-back Swap



17


Triangle Arbitrage

USDJPY 94.5100

$

€¥

Beginning USD$5,000,000

EURUSD 1.2897

€3,876,871EURJPY 123.58

¥479,103,668

Ending USD$5,069,344



18


Currency Performance


1/1/1990

1/1/1991

1/1/1992

1/1/1993

1/1/1994

1/1/1995

1/1/1996

1/1/1997

1/1/1998

1/1/1999

1/1/2000

1/1/2001

1/1/2002

1/1/2003

1/1/2004

1/1/2005

1/1/2006

1/1/2007

1/1/2008

1/1/2009

1/1/2010

1/1/2011

1/1/2012

1/1/201340%

60%

80%

100%

120%

140%

160%

180%

200%

EURUSDJPYUSDCADUSDGBPUSD


19



US Dollar Index measures the performance of the US dollar against a basket of foreign currencies. The index provides a broad measure of the relative strength or weakness of the US dollar. The index has been changed only one once, when the Euro was created subsuming several individual European currencies.

EUR 57.6%JPY 13.6%GBP 11.9%CAD 9.1%SEK 4.2%CHF 3.6%

Current weights



20




1/1/1976

5/1/1977

9/1/1978

1/1/1980

5/1/1981

9/1/1982

1/1/1984

5/1/1985

9/1/1986

1/1/1988

5/1/1989

9/1/1990

1/1/1992

5/1/1993

9/1/1994

1/1/1996

5/1/1997

9/1/1998

1/1/2000

5/1/2001

9/1/2002

1/1/2004

5/1/2005

9/1/2006

1/1/2008

5/1/2009

9/1/2010

1/1/2012

5/1/20130

20

40

60

80

100

120

140

160

US Dollar Index


21


Currency Styles

1. Carry Trade: the carry trade is when an investor sells a currency in a low interest rate county and purchases the currency in a high yielding country. This strategy is focused on capturing the spread in the interest rates, or carry, rather than making a directional bet on the exchange rate between the two. For example, borrowing at 0.25% in US dollars and investing at 7.8% in Brazilian real.

2. Trend: betting on the continuation of a price move. For example if the EURUSD is rallying, a trend following strategy would buy in anticipation of further appreciation.

3. Value: value strategies use financial methods to purchase undervalued currencies and sell overvalued ones.

1. Purchasing Power Parity2. Interest Rate Parity3. Balance of Payments



22


Currency Styles - Value

2. Purchasing Power Parity: this is an approach that is based on the “law of one price” which states that a Big Mac in China is worth the same as a Big Mac in the US, regardless of the exchange rate. PPP takes this a step further, compiling a basket of nearly identical goods in each market and rebases the exchange rate to set the price of this basket equal in both currencies.

3. Interest Rate Parity: essentially states that interest rate arbitrage (or carry) should not hold over the long term, and hence real interest rates (nominal rate minus inflation) will normalize across countries.

4. Balance of Payments: this approach essentially means the true value of a currency is that which balances the current account and the capital account. The current account is the sum of the balance of trade, or imports versus exports in an economy – it is the sum of currency transactions for trade flows. The capital account is the net change in ownership of foreign assets, essentially the sum of the currency transactions for investment flows.



23


Currency Styles

Deutsche Bank FX Indices

Carry: Currency Harvest Index takes the G10 currencies and ranks them by 3 month LIBOR rates, going short the 3 lowest rates and long the 3 highest yielding currencies. This index is rolled and rebalanced quarterly.

Trend: FX Momentum takes the G10 currencies and ranks them by their 12 month rolling return versus the dollar, going long the 3 highest returning currencies and short the three lowest returning ones. This index is rebalanced monthly.

Value: FX PPP takes the G10 currencies and ranks them by the difference between their sport rate and the purchasing power parity rate as calculated by the OECD, going long the 3 most undervalued and short the 3 most overvalued currencies. This index rebalance and rolled quarterly.



24


Currency Styles – Deutsche Bank Currency Indices


01/01/94

11/01/94

09/01/95

07/01/96

05/01/97

03/01/98

01/01/99

11/01/99

09/01/00

07/01/01

05/01/02

03/01/03

01/01/04

11/01/04

09/01/05

07/01/06

05/01/07

03/01/08

01/01/09

11/01/09

09/01/10

07/01/11

05/01/12

03/01/1340%

140%

240%

340%

440%

540%

640%

G10 Carry Index

FX Trend

FX Value Index

S&P 500


25


Currency Styles

Index Return Volatility SharpeDeutsche Bank G10 Carry 5.46% 9.07% 0.436Deutsche Bank FX Trend 4.36% 9.06% 0.315Deutsche Bank FX Value 3.37% 8.40% 0.223S&P 500 8.79% 15.28% 0.477

Carry is the best performing currency style index, providing the highest return of the currency styles, although less than equities. However, the volatility for all strategies is far less than that of equities and as a result, carry has a slightly superior Sharpe ratio to stocks.



26


Virtual Currency


Bitcoin is a peer-to-peer digital currency that functions as a medium of exchange without the intermediation of any central bank or monetary authority. It was created in January of 2009 and consists merely of encrypted digital code to prevent theft and double spending. There are currently 11.5 million bitcoins in circulation, and production will halve every four years until a total of 21 million bitcoins are in circulation.

While used extensively for illegal transactions, speculation, and hoarding (hedging against inflation), some major internet destinations such as Reddit and Baidu are now recognizing bitcoin as a legitimate medium of exchange.


http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=e7eVWHvDqo8-oM&tbnid=EbkAtRM2GFUbbM:&ved=0CAUQjRw&url=http://bgr.com/2013/04/02/bitcoin-price-increase-bubble-410256/&ei=WbNuUseSO8_eyQHw9YGgAw&bvm=bv.55123115,d.aWc&psig=AFQjCNEKrOdduvxlPZ-8TQLrY4vSBwwIcQ&ust=1383072984033142

Economy & Finance

Forex