Currency Strategy

CALLUM HENDERSON is Head of FX Strategy for a leading international bank, based in Singapore. A wide-quoted authority of both emerging and currency markets, Mr Henderson has spent the past 16 years in the financial markets in various capacities and has written articles for many leading financial journals and given seminars around the world on global currency markets.Mr Henderson is the author of three previous books covering the Asian economic story: the bestseller Asia Falling, China on the Brink (awarded Best Business Book of 1999 by the Library Journal of the US) and Asian Dawn.

• Preface to the Second Edition xiAcknowledgements xviiAbout the Author xixIntroduction 1Part One Theory and Practice 151 Fundamental Analysis: The Strengths and Weaknesses of Traditional Exchange Rate Models 171.1 Purchasing Power Parity 171.1.1 Reasons for “Misalignments” 191.1.2 Tradable and Non-Tradable Goods 201.1.3 PPP and Corporate Pricing Strategy 20Example 1 20Example 2 221.1.4 PPP and the Real Exchange Rate 241.2 The Monetary Approach 251.2.1 Mundell–Fleming 271.2.2 Theory vs. Practice 291.2.3 A Multi-Polar rather than a Bi-Polar Investment World 301.2.4 Two Legs but not Three 301.2.5 Implications for New EU Member States 311.3 The Interest Rate Approach 321.3.1 Real Interest Rate Differentials and Exchange Rates 341.4 The Balance of Payments Approach 341.4.1 A Fixed Exchange Rate Regime 351.4.2 A Floating Exchange Rate Regime 361.4.3 The External Balance and the Real Exchange Rate 371.4.4 REER and FEER 381.4.5 Terms of Trade 391.4.6 Productivity 401.5 The Portfolio Balance Approach 42Example 421.6 Summary 442 Currency Economics: A More Focused Framework 472.1 Currencies are Different 482.1.1 (In)Efficient Markets 482.1.2 Speculation and Exchange Rates: Cause, Effect and the Cycle 49Example 502.1.3 Risk Appetite Indicators and Exchange Rates 532.2 Currency Economics 582.2.1 The Standard Accounting Identity for Economic Adjustment 58Example 1 59Example 2 602.2.2 The J-Curve 62Example 632.2.3 The Real Effective Exchange Rate 632.3 Summary 643 Flow: Tracking the Animal Spirits 653.1 Some Examples of Flow Models 693.1.1 Short-Term Flow Models 703.1.2 Medium-Term Flow Models 773.1.3 Option Flow/Sentiment Models 813.2 Speculative and Non-Speculative Flows 823.3 Summary 844 Technical Analysis: The Art of Charting 854.1 Origins and Basic Concepts 854.2 The Challenge of Technical Analysis 864.3 The Art of Charting 874.3.1 Currency Order Dynamics and Technical Levels 874.3.2 The Study of Trends 904.3.3 Psychological Levels 904.4 Schools of (Technical) Thought 1004.5 Technical Analysis and Currency Market Practitioners 102Part Two Regimes and Crises 1055 Exchange Rate Regimes: Fixed or Floating? 1075.1 An Emerging World 1085.2 A Brief History of Emerging Market Exchange Rates 1095.2.1 The Rise of Capital Flows 1105.2.2 Openness to Trade 1115.3 Fixed and Pegged Exchange Rate Regimes 1115.3.1 The Currency Board 1125.3.2 Fear and Floating 1125.3.3 The Monetary Anchor of Credibility 1135.4 Exchange Rate Regime Sustainability – A Bi-Polar World? 1145.5 The Realworld Relevance of the Exchange Rate Regime 1165.6 Summary 1186 Model Analysis: Can Currency Crises be Predicted? 1196.1 A Model for Pegged Exchange Rates 1206.1.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation 1206.1.2 Phase II: The Irresistible Force and the Moveable Object 1216.1.3 Phase III: The Liquidity Rally 1236.1.4 Phase IV: The Economy Hits Bottom 1246.1.5 Phase V: The Fundamental Rally 1256.2 A Model for Freely Floating Exchange Rates 1286.2.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation 1286.2.2 Phase II: Speculators Join the Crowd – The Local Currency Continues to Rally 1286.2.3 Phase III: Fundamental Deterioration – The Local Currency Becomes Volatile 1296.2.4 Phase IV: Speculative Flow Reverses – The Local Currency Collapses 1306.3 Summary 133Part Three The Real World of the Currency Market Practitioner 1357 Managing Currency Risk I – The Corporation: Advanced Approaches to Corporate Treasury FX Strategy 1377.1 Currency Risk 1387.2 Types of Currency Risk 1407.2.1 Transaction Risk 1407.2.2 Translation Risk 140Example 1417.2.3 Economic Risk 1427.3 Managing Currency Risk 1437.4 Measuring Currency Risk – VaR and Beyond 1437.5 Core Principles for Managing Currency Risk 1447.6 Hedging – Management Reluctance and Internal Methods 1457.7 Key Operational Controls for Treasury 1477.8 Tools for Managing Currency Risk 1477.9 Hedging Strategies 1487.9.1 Hedging Transaction Risk 1487.9.2 Hedging the Balance Sheet 150Example 1507.9.3 Hedging Economic Exposure 1517.10 Optimization 1527.11 Hedging Emerging Market Currency Risk 1537.12 Benchmarks for Currency Risk Management 1537.13 Budget Rates 1547.14 The Corporation and Predicting Exchange Rates 1557.15 Summary 155Additional Section for the Second Edition 1568 Managing Currency Risk II – The Investor: Currency Exposure within the Investment Decision 1638.1 Investors and Currency Risk 1638.2 Currency Markets are Different 1648.3 To Hedge or not to Hedge – That is the Question! 1658.4 Absolute Returns – Risk Reduction 1658.4.1 Passive Currency Management 1668.4.2 Risk Reduction 166Example 1678.5 Selecting the Currency Hedging Benchmark 167Example 1688.6 Relative Returns – Adding Alpha 1698.6.1 Active Currency Management 1698.6.2 Adding “Alpha” 1698.6.3 Tracking Error 1718.7 Examples of Active Currency Management Strategies 1728.7.1 Differential Forward Strategy 1728.7.2 Trend-Following Strategy 173Example 1738.7.3 Optimization of the Carry Trade 1758.8 Emerging Markets and Currency Hedging 1768.9 Summary 178References 178Additional Section for the Second Edition 1799 Managing Currency Risk III – The Speculator: Myths, Realities and How to be a Better Currency Speculator 1879.1 The Speculator – From Benign to Malign 1879.2 Size Matters 1919.3 Myths and Realities 1919.4 The Speculators – Who they are 1929.4.1 Interbank Dealers 1929.4.2 Proprietary Dealers 1939.4.3 “Hedge” Funds 1949.4.4 Corporate Treasurers 1959.4.5 Currency Overlay 1969.5 The Speculators – Why They Do It 1979.6 The Speculators – What They Do 1979.6.1 Macro 1989.6.2 Momentum (and Fellow Travellers) 1989.6.3 Flow 1999.6.4 Technical 1999.7 Currency Speculation – A Guide 1999.8 Summary 202Additional Section for the Second Edition 20310 Applying the Framework 20910.1 Currency Economics 20910.2 Flow Analysis 20910.3 Technical Analysis 21010.4 Long-Term Valuation 21110.5 The Signal Grid 21110.6 Risk Appetite Indicators 21110.7 Exchange Rate Regimes 21210.8 Currency Crises and Models 21210.8.1 CEMC 21210.8.2 The Speculative Cycle 21310.9 Managing Currency Risk I – The Corporation 21310.9.1 Types of Currency Risk 21310.9.2 Internal Hedging 21410.9.3 Key Operational Controls for Treasury 21410.9.4 Optimization 21410.9.5 Budget Rates 21410.10 Managing Currency Risk II – The Investor 21510.10.1 Absolute Returns: Risk Reduction 21510.10.2 Selecting the Currency Hedging Benchmark 21610.10.3 Relative Returns: Adding Alpha 21610.10.4 Tracking Error 21710.10.5 Differential Forward Strategy 21710.10.6 Trend-Following Strategy 21710.10.7 Optimization of the Carry Trade 21710.11 Managing Currency Risk III – The Speculator 21810.12 Currency Strategy for Currency Market Practitioners 21810.12.1 Currency Trading 218Example 21910.12.2 Currency Hedging 220Example 22210.13 Summary 22411 Emerging World: New Growth Markets for Global FX 22511.1 The Growth of Emerging Markets as an Asset Class 22511.2 Increasing Importance of EM Currencies 22711.3 Explosive Growth in Asian Currencies 22811.4 Asian NDF Markets: Growth and Liberalization 23011.5 Emerging European Currencies 23111.6 Latin American Currencies 23211.7 Summary 232Conclusion 235Index 239