BT: Understanding currency markets

Business Times - 14 Nov 2007

Understanding currency markets

K DUKER discusses the four main drivers of currency markets that investors need to follow closely: central bank behaviour, a nation's trade balance, commodity prices, and domestic equity market strength

THE popularity of foreign exchange as an asset class continues to grow. Pension funds, institutional and retail investors are increasingly using this market to potentially generate excess returns and improve portfolio diversification. However, growth in the popularity of FX has not necessarily been matched by a greater understanding of how this market works.

Foreign exchange is not easy. It requires research and a degree of expertise.

A sensible approach requires investors to first understand who participates in currency markets, how excess returns are generated and what drives valuations. Trading decisions should be supported by three key elements: access to comprehensive, timely and informed research; a personal definition of risk; and a platform that allows you to trade quickly, efficiently and in all market conditions.

First, the market. Trading volumes in currency markets have grown significantly over the past three years. The Bank for International Settlements (BIS), the bank for central banks, points to an unprecedented 71 per cent increase in average daily turnover in global FX markets between April 2004 and April 2007 to US$3.2 trillion, based on current exchange rates.

What has driven this growth? A key contributor has been an increase in global trade. As more goods and services move across borders, the need for companies to hedge their foreign exchange risk grows. Notable, however, is what the BIS describes as 'a significant expansion in the activity of investor groups including hedge funds, which was partially facilitated by substantial growth in the use of prime brokerage, and retail investors'.

In other words, a greater number of participants in global FX markets are seeking to generate investment returns rather than simply manage currency risks. This is concurrent with Deutsche Bank research that shows the market is made up of two main participants: liquidity seekers, such as companies, that use FX to manage currency risks related to their operations; and profit seekers, which participate in currency markets to make money.

The growth in volumes attributed to profit seekers has been the most significant development in global currency markets in recent years. Deutsche Bank estimates that these participants now account for approximately 25-50 per cent of all market activity.

It is the difference in priorities between liquidity seekers and profit seekers which generates excess returns from currency markets. Liquidity seekers don't mind paying to manage currency risks - a service that profit seekers are all too happy to provide in the hope of generating a return.

There are a number of factors that drive currency markets. Changes in a country's macroeconomic situation have a major short-term influence. Economic data releases, policy decisions and political events cause economists and traders alike to re-appraise their outlook on a country's currency daily. Long term, the perceived strength of a nation's economy is often reflected in its currency. An economy that is growing quickly will likely attract investors from abroad seeking higher returns.

There are four main drivers of currency markets that investors need to follow closely: central bank behaviour, a nation's trade balance, commodity prices, and domestic equity market strength.

Interest rates

Central bank rates are probably the most influential factor in determining a currency's value. Higher interest rates drive demand for government bonds, attracting foreign investment and encouraging the repatriation of overseas funds. This increases demand for the currency and makes it stronger. Therefore, any move to increase interest rates - or any development that could cause a central bank to increase interest rates - will tend to make traders bullish on that currency. The reverse also applies.

A nation's trade balance is a key indicator of a country's economic health. A trade deficit causes a weakening of the currency as more financial resources flow out of the country than what flow in.

For foreign exchange markets, any unexpected move away from a nation's trade balance benchmark will usually trigger increased trading and a price movement.

Another major international influence on a currency's value is the price of commodities - particularly petroleum. A rise, especially a sharp unexpected spike, in the price of oil will negatively affect the currency of oil-importing nations, such as the United States, and positively strengthen the currency of an oil exporter, such as Canada. High global demand for commodities has also benefited commodity exporters such as Australia, which has seen its currency hit 18-year highs against the US dollar.

The overall direction in equity prices and dramatic short-term market moves tend to have an impact on currency valuations, as money flows into countries with rising equity markets and vice versa. Equity markets also tend to serve as a sentiment barometer for a country's economic prospects - the more positive the sentiment for a country's economy, the greater the demand for its assets.

Following and understanding these developments is time intensive and requires a great deal of expertise. This brings us to the first key element required to trade currencies - research.
Credible, timely and relevant research is critical for FX investors in keeping abreast of the latest developments in global currency markets. Research is available in many forms, either through brokerage firms or research houses.

As data is released daily and from a variety of sources, access to a single resource is advantageous. It is important to make sure your trading system or broker can provide this service.

The second key element - risk - is less tangible and highly personal. All markets require a degree of risk in order to produce returns and currency markets are no different. What is important is to understand these risks and your aversion to them.

In practical terms, investors can apply a range of measures to limit their risk. Trading positions can be structured with stop-loss limits, whereby a position will unwind if losses reach a certain level. Diversification across currencies and markets can also be an effective way to manage risk. This could involve diversifying positions across different regions or investing in currencies from countries that do not share close economic links or major trading partners.

Counter-party

The third and final element is choosing the right counter-party. This falls into two parts: price and market access.

Currency markets are the most liquid of the world's financial markets and also the fastest moving. Investors, therefore, need access to consistent, streaming prices and the ability to execute trades in all market conditions. Choosing the wrong counter-party could mean losing the ability to trade when you need it most. In general, a good counter-party can be described as one that has 24-hour access to global currency markets, manages large institutional trading flows and has the ability to offer prices during difficult market conditions.

For investors that do not have access to industry trading systems, technological advances have allowed Web-based trading platforms to provide seamless access to global currency markets, six days a week, 24 hours a day. There are a number of electronic trading platforms available in the market; however, not all are equal. Ensure you understand how to use your trading system, what resources it offers in terms of information and research and, crucially, the level of ongoing support.

Investors, both institutional and retail, are still coming to terms with how to use foreign exchange as an asset class. The diversification and potential yield benefits offered by FX markets are, however, clear.

Trading FX is not easy. But if you are prepared to learn, currency markets can offer fantastic potential for enhancing returns and improving diversification in your investment portfolio.

K Duker is director, dbFX - Asia Pacific, Deutsche Bank